Traders and investors use the Parabolic SAR Indicator to set trailing stops and to identify trend reversals. Developed by J. Welles Wilder Jr., the creator of the RSI Indicator and the DMI, the Parabolic SAR is also referred to as the stop-and-reversal indicator (SAR stands for stop and reversal).
For those interested in how the Parabolic SAR Indicator is calculated, please see the end of this article for the Parabolic SAR Formula.
The Parabolic Sar Indicator is plotted as a dotted line that follows the price up and down. Each dot or point represents another observation based on the period of the chart (five minute, hourly, daily, weekly, etc). When the Parabolic SAR Indicator turns up it is a sign there is a reversal for the underlying security. The same holds when the parabolic sar indicator turns down, flagging that the underlying security is reversing its trend and turning down.
As the price of the asset rises, the parabolic sar indicator rises with it. With each new move in the direction of the trend, the Parabolic Sar accelerates with the trend creating a parabolic curve, hence part of its name. Eventually the indicator catches up with the price, especially as the momentum of the trend slows. This pattern of catching up to the momentum of the price trend is what makes the Parabolic SAR so useful as a trailing stop indicator.
Some traders only use the Parabolic SAR Indicator as a trailing stop, while others find it works well as a trend-changing indicator. Wilder recommended determining the trend first using an indicator such as the Average Directional Index and then using the Parabolic SAR to monitor the trend looking for reversals and as a trailing stop. If you have identified the trend is up, then when the Parabolic SAR moves below the price it is a buy sign. In a downtrend, sell when the parabolic sar indicator moves above the price.
The Parabolic SAR Indicator is controlled by the acceleration factor that is comprised of two variables set by the investor. The first factor is the step and the other is the maximum step. The higher the step, the more sensitive the parabolic SAR indicator is to price changes and the faster moves up. A step set up too high means the parabolic sar indicator will fluctuate above and below the price more often. The second variable, the maximum step, controls the maximum movement of the Parabolic SAR Indicator as the price moves. Typically, the step is set to 2% or 0.02 and the maximum step is set to 20% or 0.20. It is best to adjust the acceleration factor to fit the underlying asset. This requires the investor to experiment with different numbers to see what gives the best signal.
The example below shows the adjustable parameters for Intel using stockcharts.com. The acceleration variables are set to 2% (0.02) for the step function and to 20% (0.20) for the maximum stop. Buy signals are given when the Parabolic SAR Indicator falls to below the price and sell signals are given when the Parabolic SAR Indicator moves above the price. During April and May the Parabolic SAR Indicator gave several false signals as the price was trending sideways.
The Parabolic SAR Indicator works well when the asset is trending up or down. It does not work as well when the asset price is moving sideways. This is why Wilder recommends determining the direction of the trend first before employing the Parabolic SAR Indicator. The chart above shows an example of this problem.
The acceleration factor affects the speed of the Parabolic SAR Indicator. As a result, investors must adjust the step and maximum step to suit their needs. Too slow and it will give a delayed signal. Too fast and you will experience whipsaws. The Parabolic SAR Indicator assumes that the trend changes every time the indicator changes direction. This is why it is important to test your acceleration point before depending on the Parabolic SAR.
How to Use the Parabolic SAR Indicator
The Parabolic SAR Indicator has two primary uses. It can help to identify trend reversals and traders use it as a trailing stop.
The trend reversal signal takes place when the indicator moves above the price indicating the up trend is over. When the indicator falls below the price it is a sign the downtrend is over. As a result, investors can use the trend reversal signal as an entry or exit. Investors go long when the Parabolic SAR Indicator falls below the price. They go short when the price rises above the Parabolic SAR Indicator.
Using the same chart for Intel, we can see the trend
reversals indicated by the buy and sell signals. On January 23, the low was what
Wilder calls a “significant point” a low while still on the short side. Four
days later a buy signal was given indicating a reversal of the trend. Then on
As already discussed, the Parabolic SAR Indicator does not work well when the stock is trending sideways as took place in April and May.
Investors also use the Parabolic SAR as a trailing stop loss indicator. First, they confirm that the market and the asset is trending using their preferred trend indicators. Then they monitor the Parabolic SAR Indicator until they receive a sell the signal telling you the trend has changed, which triggers the stop.
Using the same chart, we can see that the buy signals tell the investor when to close their short and the sell signals tell you when to sell your long position. In most cases, the stop signal occurs after a “significant point” is reached. However, in several cases an investor would receive a false signal causing a premature sell from the stop. As with all trailing stop loss techniques, this can take place and become a part of investing.
One of the strengths of the Parabolic SAR Indicator is when you enter a position. Notice how the dots or calculated points start out going more sideways before they start to turn down or up. This helps to reduce the whipsaws during the early time in the position.
Many investors incorporate more than one type of indicator to help reduce the number of false signals. The idea is to receive confirmation from more than one indicator before making a trade. We discuss this strategy in our article titled Confirming Signals.
The Parabolic SAR is calculated independently for each price trend. When the price is in an uptrend, the Parabolic SAR Indicator appears below the price and converges upwards towards it. Similarly, on a downtrend, the Parabolic SAR Indicator appears above the price and converges downwards.
At each step within a trend, the Parabolic SAR Indicator is calculated ahead of time. That is, tomorrow's Parabolic SAR value is built using data available today.
The formula for calculating the Parabolic SAR Indicator requires several inputs including:
This brings us to the general formula for the Parabolic SAR Indicator:
Where SARn and SARn + 1 represent today's and tomorrow's SAR values, respectively.
The SAR is recursively calculated in this manner for each new period. There are, however, two special cases that will modify the SAR value:
When the trend changes direction, the first SAR value for this new trend is set to the last EP recorded on the previous trend. The EP is then reset accordingly to this period's maximum. The acceleration factor is reset to its initial value, which is usually 0.02.
The Bottom Line
The Parabolic SAR Indicator offers investors another technical analysis tool to help identify changes in trends and can be used as a trailing stop indicator. When combined with other indicators the Parabolic SAR can enhance your investing results, as long as you understand its limitations.
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