What is Parabolic SAR?

The Parabolic SAR indicator was developed by technical analyst J. Welles Wilder Jr. in the late 70s, where SAR stands for Stop and Reverse. This indicator is presented in the book New Concepts in Technical Trading Systems, along with other popular indicators, such as the Relative Strength Index. - RSI).

Wilder calls this approach the Parabolic Time/Price System, while the concept of SAR is presented as follows:

SAR stands for Stop and Reverse. This is the point of switching from a Buy position to a Sell position or vice versa. 

- Wilder, J. W., Jr. (1978). New Concepts in Technical Trading Systems (tr. 8).

Today, this system is often called the Parabolic SAR indicator, used as a tool to identify market trends and possible reversal points. Although Wilder developed many technical analysis (TA) indicators manually, they are now largely implemented by digital trading systems and charting software. As a result, the techniques no longer require manual calculations and are relatively simple to use.

How does it work?

The Parabolic SAR indicator consists of small dots located above or below the price of the asset. Processing the dots creates a parabola, but each dot represents a unique SAR value.

In short, the dots are drawn below the price when it increases and above the price when it decreases. They are also drawn during periods of consolidation, when the market is moving sideways. But then, the dots will change sides more often. In other words, the Parabolic SAR indicator is less useful when the market is volatile.

Right

The Parabolic SAR indicator can clearly indicate the direction and duration of market trends, as well as potential reversal points. Thanks to that, this indicator can help investors find good buying and selling opportunities.

Some traders also use the Parabolic SAR indicator to identify price levels to prevent losses, so their stops move along with the market trend. Such a technique is often called trailing stop-loss. 

Essentially, it allows traders to lock in the profits they have made so they can stop buying or selling as soon as the trend reverses. In some situations, it can also prevent traders from closing profitable buy or sell positions or entering a trade too early.

Restrictions

As mentioned, the Parabolic SAR indicator is especially useful in volatile markets, but not so useful when the market is volatile. When the market does not have a clear trend, the indicator can provide false signals, which can cause significant losses.

A volatile market (moving up and down too quickly) can also provide many misleading signals. So, the Parabolic SAR indicator tends to work best when prices change at a gradual pace.

Another thing to consider is the indicator's sensitivity, which can be adjusted manually. The higher the sensitivity, the higher the chance of false signals occurring.

In some cases, false signals can encourage traders to close profitable positions too early and sell assets that still have profit potential. Even worse, false breakout signals can give investors a false sense of optimism, causing them to buy too early.

Finally, because the indicator does not consider trading volume, it does not provide much information about the strength of a trend. Although large market movements cause the gap between each dot to widen, that should not be taken as a sign of a strong trend.

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

Wilder recommends using the Average Directional Index along with the Parabolic SAR indicator to evaluate the strength of trends. Additionally, moving averages, or RSI indicators can also be included in the analysis before entering into a position.

Calculate the Parabolic SAR indicator

Today, computer programs perform automatic calculations. But for those interested, this section will briefly explain how the Parabolic SAR indicator is calculated.

SAR scores are calculated based on available market data. So, to calculate today's SAR, we use yesterday's SAR, and to calculate tomorrow's SAR value, we use today's SAR.

During an asset's bullish period, the SAR value is calculated based on its previous peak. During the asset's bearish phase, its bottoms are considered. Wilder calls the highest and lowest points in a trend Extreme Points (EP). However, the equation for calculation during bullish and bearish periods is different.

For periods of rising prices:

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

For periods of falling prices:

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 level reaches a new high (during an uptrend) or a new low (during a downtrend). 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 change the sensitivity of the indicator. AF higher than 0.2 will increase sensitivity (more reversal signals). AF lower than 0.2 results in the opposite trend. However, Wilder mentioned in his book that a value of 0.02 is generally the most suitable value.

Although the calculation is relatively simple to use, some traders have asked Wilder how to first calculate the SAR, considering that the equation requires previous values. According to him, the first SAR can be calculated based on the most recent EP before the market reversed.

Wilder recommends traders go back to their charts to find a clear reversal and then use that EP as the first SAR value. Successive SARs can be calculated until the nearest market price is reached. 

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

summary

Although created in the 1970s, Parabolic SAR is still widely used today. Investors can apply it to many investment options today, 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 that they have a good understanding of the financial markets and technical analysis. You should also have appropriate trading and risk management strategies to minimize inevitable risks.