While doing your research about trading, you come across various resources tools to help you in the process. Technical indicators crop up very early on this journey. Technical indicators are pattern-based signals used by traders. They identify opportunities and predict price behaviour by analyzing historical trading statistics. They are based on data like price, open-interest and volume. Today we are discussing a popular technical indicator, the parabolic SAR. We will understand the basics of Parabolic SAR and learn how to start trading with it. We will also discuss the limitations of the tool.
J. Welles Wilder Jr. introduced the parabolic SAR indicator in 1978 and till date it helps traders get an edge over others by determining trend direction and predicting price reversal. The indicator highlights the direction in which an asset is currently moving and provides entry and exit points. It uses a trailing SAR, also known as ‘ Stop And Reverse’ system, to provide these entry and exit points.
On a chart, depending on the direction in which the price is moving, the parabolic SAR indicator appears as a series of dots below or above the asset’s price. When price trends upward, a dot gets placed below the price signifying a bullish signal. When it trends downward, the dot gets placed above the price, indicating that the momentum will remain bullish. Hence, when the position of the dots flips, a change in price direction is expected to be on its way very soon. Say, if the dots have been below the price and they flip to be above the price, it could indicate a future drop in the price.
Now these dots rise along with the price of the given stock. They may start slow and pick up the pace to match the trend. The parabolic SAR is observed to move faster with the development of a trend and the dots are quick to follow the price.
While the indicator works great for determining gains during trends, it can also emit false signals when the price is moving sideways or the market is volatile with many direction changes but no significant overall gains or losses. The parabolic SAR would keep a trader in trade while the price rises. But when the overall price direction moves sideways, one should expect smaller gains or more losses if depending on the indicator.
Let’s say a trader observes a long term downtrend in the price movement of an asset. And at one point, there is a pullback in the price for a short time. A pullback refers to a situation where the direction of price goes against the current trend. In this case, there is a short window where the price reverses to an upward direction before falling again and continuing the downtrend. The indicator would keep the trader in the short trade as the pullback started. However, the price is moving sideways, and the trader would continue with a downtrending asset, according to the indicator.
The parabolic SAR is also considered an aid for setting stop-loss orders. While a stock rises, the stop-loss can be moved to match the parabolic SAR indicator. Even in a short trade, the indicator falls as the price falls. Hence, the stop-loss order can be moved after every price bar to match the indicator’s level.
As the indicator is mechanical, it is considered to be ‘on’ all the time. Which means it will always emit new signals, as price is always moving. The trader has to exercise his own judgement about whether to take up a trade or not. Like in the trade in the example we just discussed, it is better to execute shorter sales during the downtrend instead of also listening to the buy signals during the short upward spikes in the trend.
One of the resistances to the parabolic SAR is that it can result in multiple trades, sometimes too many. Some traders argue that using other tools may provide a comprehensive screenshot of a trend, and the trader can then decide to make only one or two trades, instead of buying and selling every time the dot flips without any gains. Hence, active traders use the parabolic SAR to make high-momentum moves before exiting a particular trade. Having said that, the parabolic SAR does perform its best during a steady trend. In ranging markets, where a financial instrument is hitting similar highs and lows in price, the parabolic SAR dots will flip back and forth, resulting in false trading signals in the absence of a quality trend. It is advisable to study the price chart of a trading session to gauge the direction of the trend. Parabolic SAR signals should be considered along with other indicators such as stochastic or moving average to confirm the overall trend direction.
In conclusion, the parabolic SAR is helpful in gauging price direction and for placing stop-loss orders. While it does well in a trending environment, it can also emit false signals and encourage unfavourable trades if the price begins to move sideways. Hence it should be clubbed with other indicators and in case of a genuine trend, it would be safer to use trade signals only in the direction of the overall dominant trend.