A Concise Guide to the Parabolic SAR Indicator

Understanding Parabolic SAR

The Parabolic Stop and Reverse (SAR) indicator was crafted by technical analyst J. Welles Wilder Jr. in the late 1970s. It made its debut in his book "New Concepts in Technical Trading Systems," alongside other widely-used indicators like the Relative Strength Index (RSI).

Wilder originally dubbed this approach the Parabolic Time/Price System, with the SAR concept introduced as follows:

SAR stands for Stop and Reverse. This is the point where a long trade is closed and a short trade is opened, or vice versa.

• Wilder, J.W., Jr. New Concepts in Technical Trading Systems (p. 8).

Today, this system is commonly referred to as the Parabolic SAR indicator, serving as a tool for identifying market trends and potential reversal points. While Wilder initially developed several technical analysis (TA) indicators manually, they are now integrated into most digital trading systems and charting software, making these techniques relatively straightforward to implement without manual calculations.

Mechanics of the Indicator

The Parabolic SAR indicator is represented by small dots positioned above or below the market price. The arrangement of these dots forms a parabola, with each dot representing a single SAR value.

In essence, dots are plotted below the price during an uptrend and above it during a downtrend. They are also plotted during consolidation periods when the market moves sideways. However, in this scenario, the dots will switch sides much more frequently. Consequently, the Parabolic SAR indicator is less effective during trendless markets.

Advantages

Parabolic SAR can offer insights into the direction and duration of market trends, as well as potential reversal points. As such, it may enhance traders' chances of identifying favorable buying and selling opportunities.

Some traders also utilize the Parabolic SAR indicator to determine dynamic stop-loss prices, allowing their stops to move in tandem with the market trend. This technique is often referred to as a trailing stop loss.

Fundamentally, it enables traders to secure profits already gained because their positions are closed as soon as the trend reverses. In some situations, it may also prevent traders from prematurely closing profitable positions or entering a trade too early.

Limitations

As mentioned, Parabolic SAR is particularly useful in trending markets but less so during consolidation periods. When there's no clear trend, the indicator is more likely to generate false signals, which can lead to substantial losses.

An unstable market (one that rises and falls rapidly) may also produce multiple misleading signals. Thus, the Parabolic SAR indicator tends to perform better when prices change at a more gradual pace.

Another factor to consider is the indicator's sensitivity, which can be manually adjusted. Higher sensitivity increases the likelihood of false signals occurring.

In some instances, false signals may encourage traders to close winning positions too early, selling assets that still have potential for gain. Worse still, false breakouts may give investors a misplaced sense of optimism, inducing them to buy too soon.

Lastly, as the indicator doesn't account for trading volume, it doesn't provide much information about the strength of a trend. Although large market movements cause the gap between each dot to increase, this shouldn't be taken as indicative of a strong trend.

No matter how much information traders and investors have, risks will always be part of financial markets. However, many combine Parabolic SAR with other strategies or indicators as a way to minimize risks and offset limitations.

Wilder recommended using the Average Directional Index alongside Parabolic SAR to assess trend strength. Additionally, moving averages or the RSI indicator can also be incorporated into the analysis before entering a position.

Calculating Parabolic SAR

Today, computer programs perform the calculations automatically. However, for those interested, this section provides a brief explanation of the Parabolic SAR calculation.

SAR points are calculated based on existing market data. Thus, to calculate today's SAR, we use yesterday's SAR, and to calculate tomorrow's value, we use today's SAR.

During an uptrend, the SAR value is calculated based on previous highs. During downtrends, previous lows are considered. Wilder referred to the highest and lowest points of a trend as Extreme Points (EP). However, the equation is not the same for uptrends and downtrends.

For uptrends:

SAR = Previous SAR + AF x (Previous EP – Previous SAR)

For downtrends:

SAR = Previous SAR – AF x (Previous SAR – Previous EP)

AF stands for acceleration factor. It starts at 0.02 and increases by 0.02 whenever the price reaches a new high (for uptrends) or a new low (for downtrends). However, if the 0.20 limit is reached, this value is maintained for the duration of that trade (until the trend reverses).

In practice, some chartists manually adjust the AF to alter the indicator's sensitivity. An AF above 0.2 will result in higher sensitivity (more reversal signals). An AF below 0.2 does the opposite. Still, Wilder stated in his book that 0.02 increments worked best overall.

While the calculation is relatively simple to use, some traders asked Wilder how to calculate the first SAR, given that the equation requires previous values. According to him, the first SAR can be calculated based on the last EP before a market trend reversal.

Wilder recommended that traders go back on their chart to find a clear reversal and then use that EP as the first SAR value. The subsequent SAR could then be calculated until the latest market prices were reached.

For example, if the market is in an uptrend, a trader could go back a few days or weeks until they find a previous correction. They then find the local bottom (EP) for that correction, which could then be used as the first SAR for the following uptrend.

Final Thoughts

Although dating back to the 1970s, Parabolic SAR is still widely used today. Investors can apply it to many of today's investment alternatives, including Forex, commodities, stocks, and cryptocurrency markets.

But no market analysis tool can guarantee 100% accuracy. Therefore, before using Parabolic SAR or any other strategy, investors should ensure they have a good understanding of financial markets and technical analysis. They should also have appropriate trading and risk management strategies to mitigate inevitable risks.