Introduction to the Parabolic SAR

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Introduction to the Parabolic SAR

The parabolic SAR seeks to provide traders with an advantage by identifying the direction in which an asset is going as well as offering entry and exit points. In this post, we’ll go over the fundamentals of this indicator and teach you how to use it in your trading strategy. We’ll also look at some of the indicator’s disadvantages.

Key Takeaways

  • J. Welles Wilder Jr. invented the parabolic SAR indicator, which traders use to identify trend direction and probable price reversals.
  • To identify ideal departure and entry positions, the technical indicator employs a trailing stop and reverse approach known as “SAR,” or stop and reverse.
  • The parabolic SAR indication shows as a succession of dots on a chart, either above or below an asset’s price, depending on which way the price is going.
  • When the price is rising higher, a dot is put below it, and when it is heading downward, a dot is placed above it.

The Indicator

The parabolic SAR is a technical indicator that is used to assess the price direction of an asset and to alert traders when the price direction changes. The parabolic SAR, often known as the “stop and reverse system,” was created by J. Welles Wilder Jr., the developer of the relative strength index (RSI).

The indicator appears as a sequence of dots above or below the price bars on a chart. A dot below the price is considered a bullish indicator. A dot above the price, on the other hand, indicates that the bears are in charge and that the momentum is likely to continue lower. When the dots flip, it suggests that a prospective price direction shift is underway. For example, if the dots are above the price, flipping below the price might indicate a future increase in price.

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As the price of a stock increases, so will the dots, initially slowly, then quickly picking up pace and speeding with the trend. As the trend develops, the SAR begins to move quicker, and the dots quickly catch up to the price.

The chart below indicates that although the indicator works well for catching gains during a trend, it may generate a lot of false signals when the price swings sideways or trades in a rough market. While the price soared, the indication would have kept the trader in the deal. A trader can anticipate greater losses and/or modest gains while the price is going sideways.

Image by Sabrina Jiang © Investopedia2020

The chart below depicts a downtrend, and the indicator would have kept the trader in a short trade (or out of longs) until the upward pullbacks occurred. When the downturn continued, the indicator reintroduced the trader.

The parabolic SAR may also be used to create stop-loss orders. When a stock is rising, adjust the stop-loss to correspond with the parabolic SAR indicator. A short trade follows the same logic—as the price declines, so does the indicator. After each price bar, adjust the stop-loss to match the level of the indicator.

Image by Sabrina Jiang © Investopedia2020

This mechanical indicator will constantly provide fresh cues to go long or short. It is up to the trader to decide which deals to enter and which to avoid. During a downturn, for example, it is preferable to accept just short sells, as seen in the chart above, rather than purchase signals as well.

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Indicators to Complement to the Parabolic SAR

It is preferable in trading to have numerous indicators validate a single signal rather than relying simply on one indicator. Use additional indicators to supplement the SAR trading signals, such as the stochastic, moving average, or ADX.

SAR sell signals, for example, are far more persuasive when the price is trading below a long-term moving average. The price being below a long-term moving average indicates that the sellers are in charge and that the recent SAR sell signal might be the start of another wave down.

Similarly, if the price is above the moving average, concentrate on buying indications (dots move from above to below).The SAR indicator may still be utilized as a stop-loss, but short trades are not advised since the longer-term trend is up.

Image by Sabrina Jiang © Investopedia2020

A counter-argument to the parabolic SAR is that it may result in a large number of transactions. The chart above depicts many deals. Some traders say that if the moving average had been used alone, the whole up move would have been caught in a single deal. As a result, active traders who wish to capture a high-momentum move and subsequently exit the transaction generally utilize the parabolic SAR.

The parabolic SAR works best in markets with a consistent trend. The parabolic SAR whipsaws back and forth in range markets, giving erroneous trading signals.

Whether there is a quality trend or not, the parabolic SAR is ‘always on’ and continuously producing indications. As a result, many signals may be of poor quality since no substantial trend exists or develops after a signal.

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The Bottom Line

The parabolic SAR is used to determine the direction of a stock and to place stop-loss orders. The indicator gives fantastic results while the price is trending, but it creates numerous false signals and loses trades when the price begins to move sideways. Only trade in the direction of the dominating trend to help filter out some of the bad trade signals. Other technical techniques, such as the moving average, may help in this situation.

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