The parabolic stop and reverse is a tool of technical analysis, the school of investing that believes that history repeats in the stock market and as such one can make gains by predicting the trajectory of a security based on its stock chart. The parabolic SAR was developed by the famous trader Welles Wilder in the 70s. Wilder’s other notable contributions to technical charts include tools Average True Range, Relative Strength Index, and Average Directional Index.
The parabolic SAR is a trend-following indicator that helps traders gauge the direction of price movement of a security. The PSAR indicator appears in technical charts as a series of dots situated either above or below candlestick bars. When the series of dots appear below the price line, it is considered to be a bullish signal — meaning that the uptrend will continue for a while. However, when they are above the price line, it implies that the sellers in the market are in control and that the downward trend would hold for some time.
The parabolic SAR indicator is a lagging indicator and could be helpful in setting a trailing stop loss or deciding on entry or exit points based on asset prices tending to stay inside a parabolic curve when there’s a strong trend in the market.
Calculating the parabolic SAR
The parabolic SAR indicator uses the latest extreme price (EP) along with an acceleration factor (AF) to find out where the series of dots will be located. EP is the higher most high that the asset has reached in an uptrend and the lowermost low for that it touches in a downtrend — and is updated every single time a new EP is reached. The AF is set at a default of 0.02, and increased by 0.02 for each new EP, with a maximum value of 0.20.
Here’s how PSAR is calculated for a security that is in uptrend:
PSAR = Prior PSAR + Prior AF (Prior EP – Prior PSAR)
Here’s how PSAR is calculated for a security that is in downtrend:
PSAR = Prior PSAR – Prior AF (Prior PSAR – Prior EP)
This formula helps in determining the position of a dot below the rising trendline or above the falling trendline. One can also connect the dots with a line based on preference. The series of dots help indicate the current price momentum of a security.
How to trade the parabolic SAR indicator
Usually while using the PSAR, traders buy an asset if the dots shift below the candlestick bars, implying an upward momentum in the price of the security, and sell or short-sell in case the series of dots appear above the candlesticks — indicating downward momentum.
Consequently, there will be constant trade signals since a trader using it will always have a position in the asset. That might be useful if the security is swinging back and forth, thus making the trader a gain on each trade. However, if the asset is moving only a little in both directions, then the barrage of trade signals could lead to a series of losing trades.
As such, it is preferable to study the price chart of the trading session to gauge if there’s a strong upward or downward trend. Another technical indicator such as a moving average should be used to make sure of the overall trend direction. In case there is a genuine trend, a trader might use the trade signals in the direction of the overall trend. For instance, if there appears to be a downtrend, then a trader might take short trade signals when the dots shift to the top of the candlesticks and exit when the dots flip positions to appear below.
The best use-case scenario of the PSAR indicator is with assets that are showing a strong trend, which happens 30% of the time, according to estimates made by Wilder. This might mean that PSAR would be prone to whipsaws more than half of the time or when an asset is not trending. A trader must be mindful of the fact that parabolic SAR is the most useful in determining a security’s price direction and for placing stop-loss orders based on the evidence. Moreover, the parabolic SAR indicator could give a lot of false signals when the asset’s price is swinging sideways. Therefore, it is best to use it in conjunction with other technical indicators so that poor trade signals can be filtered out.