How to Trade With Parabolic Stop and Reverse (Parabolic SAR)
The Parabolic Stop and Reverse, more commonly known as the Parabolic SAR, is a trend following indicator developed by J. Welles Wilder. The Parabolic SAR is displayed as a single parabolic line (or dots) underneath the price bars in an uptrend, and above the price bars in a downtrend.
The Parabolic SAR has three primary functions:
- Highlighting the current price direction (trend).
- Providing potential entry signals.
- Providing potential exit signals.
Each of these applications is discussed in further detail below.
Parabolic SAR Calculation
The Parabolic SAR (PSAR) indicator uses the most recent extreme (highest and lowest) price (EP), along with an acceleration factor (AF), to determine where the indicator dots will appear.
The Parabolic SAR is calculated as follows:
Uptrend: PSAR = Prior PSAR + Prior AF (Prior EP - Prior PSAR)
Downtrend: PSAR = Prior PSAR - Prior AF (Prior PSAR - Prior EP)
EP = Highest high for an uptrend, and lowest low for a downtrend updated each time a new EP is reached.
AF = Default of 0.02, increasing by 0.02 each time a new EP is reached, with a maximum of 0.20.
What this calculation does is create a dot (which can be connected with a line if desired) below rising price action, or above falling price action. The dots/line help highlight the current price direction. The dots are always present, though, which is why the indicator is called a 'stop and reverse'. When the price falls below the rising dots, the dots flip on top of the price bars. When the price rallies through falling dots, the dots flip below the price below.
Luckily, charting software does all these calculation for us. Figure 1 shows what the Parabolic SAR looks like on a chart.
How to Trade With the Parabolic SAR
The basic use of the Parabolic SAR is to buy when the dots move below the price bars (signaling an uptrend) and sell/short-sell when the dots move above the price bars (signaling a downtrend).
This will result in constant trade signals, though, as the trader will always have a position. That can be good if the price is making big swings back and forth--producing a profit on each trade--but when the price is only making small moves in each direction, these constant trade signals can produce many losing trades in a row.
Therefore, it is better to analyze the price action of the day to determine if the trend (if there is one) is up or down. Another indicator such as a moving average or trendlines can also be used to establish the overall trend direction. If there is a trend, only take trade signals in the direction of the overall trend. For example, if the trend is down (based on your analysis), only take short trade signals--when the dots flip on top of the price bars--and then exit when the dots flip below the price bars.
In this way, the indicator is utilized for its strength: catching trending moves. If you have established an overall trend, then hopefully you won't need to worry about the indicator's weakness: non-profitable trade signals when there isn't a trend.
Figure 2 shows some potential short trade entries in a downtrend, as well as the exits. It also shows a period where the price moved sideways; that period would not have been ideal for taking trades based on the Parabolic SAR.
Pros and Cons of the Parabolic SAR
The main advantage of the indicator is that during a strong trend the indicator will highlight that strong trend, keeping the trader in the trending move. The indicator also gives an exit when there is a move against the trend, which could signal a reversal. Sometimes this ends up being a good exit, as the price does reverse; other times it isn't a great exit because the price immediately begins to move in the trending direction again.
The major drawback of the indicator is that it will provide little analytical insight or good trade signals during sideways market conditions. Because there is no trend present, the indicator will constantly flip-flop above and below the price. This type of price action can last all day, so if a day trader relies solely on the Parabolic SAR for trade signals, in this case, it could be a big losing day .
That is why it is recommended traders learn to identify the trend--through reading price action or with the help of another indicator--so that they can avoid trades when a trend isn't present, and take trades when a trend is present.