What is the Parabolic SAR indicator?

The Parabolic Stop and Reversal (SAR) indicator was developed in the late 1970s by technical analyst J. Welles Wilder Jr. He first mentioned it and other popular indicators such as the Relative Strength Index (RSI) in his book New Concepts in Technical Trading Systems.

In fact, Wilder calls this method the “Parabolic Time/Price System” and the concept of SAR is as follows:

“SAR” stands for “Stop and Reversal” and is generally the point where longs exit and shorts enter (and vice versa).

- Wilder, J. W., Jr. (1978).《New Concepts in Technical Trading Systems》（第8页）。

Today, the system is commonly known as the "Parabolic Indicator" and is often used as a tool to identify market trends and potential reversal points. Although Wilder calculated many technical analysis (TA) indicators manually at the time, they are now integrated into many digital trading systems and charting software. Therefore, these techniques no longer require manual calculations and are relatively simple to use.

How does it work?

The Parabolic SAR indicator consists of a number of data points above or below the market price. The distribution of these points is a parabola, but each point represents a single SAR value.

In short, the dots are located below the price in an uptrend and below the price in a downtrend. The same dots appear during a sideways market consolidation period. However, in this case, the dots appear more frequently on both sides. In other words, the Parabolic SAR indicator has no use in a non-trending market.

benefit

The parabolic SAR indicator can provide a reference for the direction and duration of market trends as well as potential reversal points. Therefore, it helps investors find the right time to buy and sell.

Some traders also use the Parabolic SAR to determine a dynamic stop price, so that their stop loss follows the market trend. This technique is often called a "trailing stop."

Essentially, the Parabolic SAR allows traders to lock in profits because they will be liquidated if the trend reverses. In some cases, it can also prevent traders from selling out of profitable positions or entering trades too early.

Limitations

As mentioned above, the Parabolic Indicator works great in trending markets, but not as well during sideways periods. When there is no clear trend, this indicator can easily give false signals, causing heavy losses.

A choppy market (one that moves up or down too quickly) can also produce many misleading signals. Therefore, the Parabolic SAR works best when prices are moving gradually.

Another point to note is the indicator sensitivity, which can be adjusted manually. The higher the sensitivity, the higher the chance of false signals.

Sometimes, false signals can cause traders to take profits too early and sell when there is still room for profit. Even worse, false upside signals can cause investors to be blindly optimistic and buy too early.

Finally, the Parabolic SAR does not take volume into account and does not provide a detailed picture of the strength of a trend. Although a significant market move will increase the distance between the two points, this does not mean that the trend is very strong.

No matter how much information traders and investors have access to, there are always risks in the financial markets. However, many people combine the Parabolic SAR with other strategies or indicators to minimize the risks and limitations.

Wilder recommends combining the parabolic SAR with the average directional index to estimate trend strength. In addition, moving averages or relative strength index (RSI) indicators can also be included in the analysis before entering a position.

Parabolic SAR Calculation

Nowadays, computer programs can perform such calculations automatically. Those who are interested can read this section for a brief introduction to the calculation of the Parabolic SAR indicator.

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

In an uptrend, the SAR value is calculated based on the high point of the previous period. In a downtrend, the low point of the previous period is used. Wilder considers the highest and lowest points in the trend as extreme points. However, the formulas for an uptrend and a downtrend are different.

Uptrend:

SAR = SAR of the previous period + AF x (EP of the previous period – SAR of the previous period)

Downtrend:

SAR = SAR of the previous period + AF x (EP of the previous period – SAR of the previous period)

AF stands for Acceleration Factor. It starts at 0.02 and increases by 0.02 every time a new high (uptrend) or a new low (downtrend) is reached. However, after reaching the limit of 0.20, the value remains unchanged during the trading period (until the trend reverses).

In fact, some chart analysts will adjust the AF value by themselves to change the sensitivity of the indicator. An acceleration factor above 0.2 will increase the sensitivity (more reversal signals). If the acceleration factor is lower than 0.2, the opposite is true. However, Wilder stated in the article that the best effect is to increase it by 0.02.

Since the calculation is relatively simple, some traders ask how Wilder calculated the first SAR value, since the formula requires the value of the previous period. According to him, the first SAR is based on the last EP value before the previous market trend reversal.

Wilder recommends that traders go back to the chart, look for a clear reversal point and use that EP as the first SAR value. Subsequent SAR values ​​can be used in calculations until the next market price is hit.

For example, if the market is trending upward, traders can look at the trend from days or weeks ago to find the previous correction point. Next, they will find the bottom value (EP) of the correction range and use this as the first SAR value for the subsequent upward trend.

Conclusion

Although the parabolic SAR indicator was invented in the 1970s, it is still widely used today. Investors can use this method in many investment products, including foreign exchange, commodities, stocks and cryptocurrency markets.

However, no market analysis tool can be completely accurate. Therefore, before using the parabolic indicator or other strategies, investors must have a deep understanding of financial markets and technical analysis. They should participate in trading moderately and implement reasonable risk management strategies to mitigate unavoidable risks.