Parabolic SAR may sound like the name of a rare bacteria. But if you are one among the millions of people who have taken up investment and trading as a way of making some extra money, you would have come across this term in a completely different context. Parabolic SAR has more to do with the health of your bank account and nothing to do with your respiratory tract.
So, what is Parabolic SAR? Parabolic SAR, also known as Parabolic Stop and Reverse, is a popular momentum indicator that can be leveraged to determine the strength and the direction of a security’s price movement. Technical traders frequently use this indicator to identify optimal trade entry and exit points, and it is considered to be one of the most reliable technical indicators in most trading circles.
Like many other tools and indicators used in technical analysis, Parabolic SAR is specifically popular for short-term trading, as it can be useful in timing the market to capture gains and avoid losses. However, unlike several other technical analysis tools, it does not carry as much stand-alone value and needs to be combined with other complementary indicators to be most effectively interpreted.
In the following sections of this article, we will discuss how you can read, interpret, and implement this indicator in your trading strategy, along with its strengths and weaknesses. So, without further ado, let us dive deep into these topics.
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Table of Contents
How to Read Parabolic SAR?
Parabolic SAR can be a little bit unusual to read for some novice investors, as it does not form convenient trend lines or distinct patterns. Instead, it simply consists of a series of dots that form parabolas. Additionally, depending on the momentum of the security’s price, these parabolas are located either above or below (at a calculated distance) the price candles.
To fully understand the readings from Parabolic SAR, it important that you familiarize yourself with the following –
- Construction of Parabolic SAR
- Parabolic SAR Indicator Calculations
- Interpreting Parabolic SAR Signals
By correctly analyzing and interpreting the readings from this indicator, you can make determinations as to how the security’s price will move in the short term. This can provide you with a considerable edge when trading that security.
Construction of Parabolic SAR
Parabolic SAR is constructed on a typical candlestick chart of a security. Each candle on the candlestick chart gives information about a security’s price for a given session. This information includes the opening price, the closing price, the session’s high, and the session’s low for the security.
When Parabolic SAR Indicator is implemented on such a price chart, for each trading session, the candle on the chart will be accompanied by a dot. When the dot is below the candle, it is a bullish indicator; when the dot is above the candle, it is a bearish signal.
Furthermore, in Parabolic SAR, the distance of the dot from the candle is driven by the momentum of the price trend. When the momentum is low, the dot will be placed relatively close to the candle. Similarly, as the momentum begins to increase, each subsequent dot will begin to be placed further and further away from its corresponding candle, with a series of these dots forming a non-linear parabola as an indicator for the compounding velocity of price momentum.
Parabolic SAR Indicator Calculations
Fortunately for all contemporary traders, there are numerous software programs and charting platforms that can run the behind the scene calculations for various technical indicators. With such platforms, without having to worry about any calculations, you can easily get the final readings for various technical indicators on the price chart of a security.
In the case of Parabolic SAR, such software and platforms are especially useful as the calculations behind this indicator are slightly complex, needing you to be up to speed on college-level statistics.
That being said, it is always good to understand the math behind various technical indicators you employ, so that you can accurately interpret the signals that they generate. So, in this section, we will now discuss how the Parabolic SAR indicator is calculated.
Before looking at the formulas, it is crucial to understand the three main components that go into calculating Parabolic SAR. These are:
- Prior Parabolic SAR (Prior PSAR) – This is the value obtained for the Parabolic SAR for the previous trading session.
- Extreme Price (EP) – This is the highest high of the current uptrend or lowest low of the current downtrend and is updated anytime a new EP is reached.
- Acceleration Factor (AF) – This is a pre-determined figure of .02 and increases by .02 each time a new EP is set, capping at .2. This constant helps to graphically demonstrate the rising momentum of a security’s price as represented on the parabola.
Now that these definitions are out of the way, it is time for us to jump straight into the mathematical formula for calculating this indicator.
The exact mathematical formula for calculating an upward trending Parabolic SAR is as follows:
Prior PSAR + Prior AF (Prior EP – Prior PSAR)
Similarly, the exact mathematical formula for calculating a downward trending Parabolic SAR is as follows:
Prior PSAR – Prior AF (Prior PSAR – Prior EP)
If these formulas are hard to conceptualize, understand that the formula for an upward trending Parabolic SAR will yield an upward-curving parabola, similar to a skateboard ramp. This indicates a rising price momentum for the security that you are analyzing. The formula for a downward trending Parabolic SAR will produce a downward-curving parabola, like a playground slide, meaning dropping price momentum for a security.
Interpreting Parabolic SAR
While somewhat difficult to calculate, Parabolic SARs are surprisingly easy to interpret once they have been appropriately plotted.
Unlike other momentum indicators, used in technical analysis, that run close to the price line and can get lost in translation, Parabolic SAR dots are very prominently located either above or below the bars in a candlestick chart, making them very distinguishable.
Traders can glean the following information when analyzing the parabolas on a candlestick chart:
- Dots below the price bars – These will form an upward trending parabola, indicating that investors are increasingly bullish, or optimistic, about a security’s outlook. This, in turn, signals that the high-volume buying will continue to drive the price of the security up. Dots below the price bars are a time when investors should consider buying.
- Dots above the price bars – These will form a downward trending parabola, indicating that traders are becoming bearish, or pessimistic, about a security’s outlook. This, in turn, signals a run of high-volume selling that will continue to drive a security’s price down. Dots above the price bars are a time when traders should consider selling to minimize losses or to avoid losing any gains.
How Reliable is Parabolic SAR Indicator in Trading?
Parabolic SAR can be very reliable in trading when there is a strong trend in place. If a security has been on a strong run of price increases over many sessions and there is a strong bullish signal from the Parabolic SAR, investors can feel confident that a buy trade will lead to tidy gains over the next several sessions. The same applies to bearish Parabolic SAR signals during a selloff.
However, during choppy or sideways trending markets, Parabolic SAR becomes increasingly unreliable. The dots will frequently flip directions before any discernible trend is formed, sending false signals and causing traders to enter into a large number of trades, many of which are not profitable enough to warrant the high commissions and/or time investment.
As most trading assets are inherently volatile, the overall reliability of Parabolic SAR is dubious when used in isolation. This is because there can be long stretches when the asset that you intend to trade does not go on to make any discernible bull or bear runs. Therefore, other complementary tools and indicators should be used in combination with Parabolic SAR to make more informed buy and sell decisions.
Improving Reliability of Parabolic SAR Indicator in Trading
As mentioned, trading Parabolic SAR has some limitations when used by itself, so to improve its reliability, it is best considered in conjunction with some other tools and technical indicators.
Several indicators and tools in technical analysis that best complement the signals from Parabolic SAR and thus improve its reliability in trading are as follows –
- Average Directional Index (ADX): Momentum in the price trend of a security is an important reading that a Parabolic SAR provides to facilitate trading decisions. Therefore, it is always good to confirm such readings on price momentum trends using a complementary indicator such as the Average Directional Index (ADX).
- Moving Average: Moving Average lines are perhaps the simplest of all indicators used in technical analysis. However, these simple lines on the price chart can considerably improve the reliability of more sophisticated technical indicators such as the Parabolic SAR. For example, sell signals generated from a bearish Parabolic SAR are much more reliable when combined with a price trend trading below a long-term moving average, as this indicates that sellers are in control of the security’s price direction.
- Chart Patterns: Chart Patterns provide traders with a reliable way to forecast the direction of an upcoming price wave. However, by solely relying on chart patterns, determining when that price wave would occur can be a bit of a challenge. This is where Parabolic SAR can come in and complement the directional guidance from chart patterns. Hence, by taking direction guidance from Chart Patterns and combining it with the Parabolic SAR’s trading strategies, you can easily make your way to trading with a high probability of success.
- Support and Resistance: Similar to the Moving Average lines, Support and Resistance is one of the most basic but powerful concepts in technical analysis. Resistance is a price level that upward trending securities have a hard time breaking through, while support is a price level that downward trending stocks have a hard time dropping below. When trading Parabolic SAR, a strong understanding of Support and Resistance levels can sizably improve the accuracy of your trades. Securities whose EPs continually break through resistance and support levels will display strong trends that could make Parabolic SAR a powerful indicator to use for making a position change.
How to Trade Using Parabolic SAR?
A nice aspect of trading Parabolic SAR is that it is very easy to trade. Simply put, when the dots are below the price line, traders should be looking to sell; when the dots are above the price line, traders should be looking to buy.
In most trading circles, Parabolic SAR is counted among the most reliable reversal indicators. A good time to trade using the Parabolic SAR is when the plotted dots cross the price line. Such crossovers indicate a reversal in trend and therefore allow investors to capitalize on ideal buy and sell points ahead of forthcoming momentum.
While the use of Parabolic SAR will be reasonably consistent, there are several trading strategies under which you can incorporate the readings from this indicator. Listed below are some of the most popular trading strategies for which Parabolic SAR can be leveraged.
- Breakout Trading Strategy
- Reversal Trading Strategy
- Pullback Trading Strategy
- Swing Trading Strategy
- Day Trading Strategy
- Buy-and-Hold Trading Strategy
There are some subtle nuances that you will want to remember when using Parabolic SAR to enter trades using any of the above listed specific approaches. Therefore, in the following sections, let us briefly discuss how you can best use this indicator with each of the above-described strategies.
Trading Strategy 1: Breakout Trading Strategy
In the Breakout Trading Strategy, an investor attempts to get in on a security trade during the initial stages of a strong price movement, either bullish or bearish. As a momentum and reversal indicator, Parabolic SAR, in combination with other complementary technical analysis tools, can be a great tool to identify when the price of a security may go on a strong run.
The key factors to consider when using Parabolic SAR at various stages of a Breakout Trading Strategy are listed as follows –
- Determining Trade Entry – The key to entering a breakout trade is making sure that a breakout has formed, and confirming that it is not a false breakout that you are dealing with. While some strategies may involve getting in at the reversal point, a breakout trader using Parabolic SAR will want to see several sessions of building momentum on the parabola before entering the trade.
- Determining Stop Loss Target – When trading breakouts, the stop-loss needs to be put in at any parabolic point below the buy-in price when making a long trade, as this may be the indication of a false signal and not a true breakout. For short trades, the stop-loss should be any parabolic point above the selling point, as the false signal could lead to forfeited gains. For more aggressive trading, you can set the stop loss for your trade at the same number of PIPs away from your trade entry point as the smallest divergence between the price and the Parabolic SARs over the last several trading sessions has been.
- Determining Take Profit Target – Take profit targets always varies based on an investor’s risk tolerance. But breakout traders generally try to capitalize on as much of the run as possible before changing their position. Therefore, traders may set the profit target for the same number of PIPs as the greatest divergence between the price and Parabolic SARs over the last several trading sessions.
Trading Strategy 2: Reversal Trading Strategy
The Reversal Trading Strategy is employed by traders who feel an asset is set for a change in fortunes. In this strategy, the investors sitting on the sidelines during a downtrend are looking for a long opportunity when indicators signal an uptrend. Similarly, the traders who remained inactive during the uptrend may be looking to sell or short-sell the security when the indicators indicate a downtrend under this strategy.
As the very nature of the Parabolic SAR is to spot reversals in a security’s momentum, it can be among the primary technical analysis tools that you use when identifying reversal trades.
Listed below are some popular ways in which you can employ the Parabolic SAR indicator at various trading stages under the Reversal Strategy –
- Determining Trade Entry – With the Reversal Trading Strategy, you will want to enter a trade when the Parabolic SAR dots cross the price line. When making a long trade, you will buy when the dot falls below the price line, and when making a short trade, you will sell when the dot rises above the price line.
- Determining Stop Loss Target – The Parabolic SAR line itself can become a useful stop-loss target when trading the reversal. When making either a long or short trade, set the stop-loss at the point where the price hits the Parabolic SAR line.
- Determining Take Profit Targets – With reversal trades, traders are generally not quite as aggressive as with breakout trades in trying to capture the entire life of a trend. As such, when taking a reversal trade using Parabolic SAR, you may set the take-profit for a certain percent of a recent EP, such as buying or selling your position when the price retraces to 85% of an EP to lock in gains.
Trading Strategy 3: Pullback Trading Strategy
The Pullback Trading Strategy is very similar to the Reversal Trading Strategy. Very simply, a pullback, also known as a correction, is a situation in which a security on a strong run takes a breath and retraces back to some of its recent price points. This can allow investors to reassess their position and determine whether to enter a trade.
Pullbacks are generally marked by periods of low volume trading in which a security tests resistance and support levels in a very narrow range. This low volatility may not be an ideal time to rely on Parabolic SAR, but the indicator can help traders decide whether to change their position during the pullback or not.
Below is how you can leverage the Parabolic SAR when trading with a Pullback Trading Strategy –
- Determining Trade Entry – With Pullback Trading Strategy, once you have identified a potential pullback in price using a complimentary analysis method, you would want to enter a trade as the Parabolic SAR approaches the price line and gets ready for a crossover. This may help you get a premium position before a strong forthcoming trend.
- Determining Stop Loss Target – When you make a change in position by either buying or selling a security, you would want to abandon that position if the security’s price goes back to intersect with the Parabolic SAR point. Hence, you would place your stop loss a few points away from the intersection of SAR points and the security’s price.
- Determining Take Profit Target – The take profit target for the Pullback Trading Strategy is similar to that of the Breakout Trading Strategy. A pullback is likely an indication of a strong continuation of paused momentum. Therefore, as an investor, you would want to capitalize on as much profit as possible when trading this strategy. To do so, you can set the take profit target for your trade at an equal number of PIPs above (in the case of a long trade) the entry point as the largest divergence range between the price line and the Parabolic SAR. In the case of short or short sell trade, your take profit will be for the same number of PIPs below the trade entry point.
Trading Strategy 4: Swing Trading Strategy
Swing Trading is a general term for a short- to medium-term trading strategy that sees investors change their position in as little as a few days to up to several months. Breakout Trading Strategy, Reversal Trading Strategy, and Pullback Trading Strategy may all be sub-strategies within the broader Swing Trading Strategy.
Since the active form of trading lives and dies by the “buy low, sell high” maxim, Swing Traders can do well by employing Parabolic SAR into their trading plan. Additionally, given the fact that Parabolic SAR is at its best when used as a short-term indicator for a security’s price momentum, its reliability increases multifold when employed for Swing Trading.
The one caveat is Swing Trading in a volatile market. As Parabolic SAR can lead to frequent losses when trading in choppy conditions, investors may want to use a different technical analysis tool, such as the Flag patterns, to capitalize on the price moves in such market conditions.
Listed below are few pointers that you must consider when using Parabolic SAR for Swing Trading –
- Determining Trade Entry – Swing traders want to enter a trade whenever they notice the Parabolic SAR crossing over the price line. This likely means that the security will, in at least the near term, experience a trend opposite of what it had been experiencing in recent sessions, so this crossover could offer ideal buying or selling conditions for Swing Trading.
- Determining Stop Loss Target – When swing trading, you should set the stop loss for your trade at a point where the price retreats to a previous resistance level (in the case of a long trade) or rises to a prior support level (in the case of a short trade). In swing trading, you will rarely have the luxury of time to allow for markets to correct themselves.
- Setting Take Profit Target – As with setting stop-loss orders, as a swing trader, you will not have time to allow for the gains to stack upon themselves. Instead, as a swing trader, your intent is to make a living by executing frequent, profitable trades for smaller amounts. Therefore, profits should be taken once the parabola starts to flatten out and the dots start retreating to the price line.
Trading Strategy 5: Day Trading Strategy
Day Trading is similar to Swing Trading, except it is done on an even tighter time frame. Day Trading refers to a situation in which a trader changes his or her position on a given security within the same trading day. This is one of the most active forms of trading that an investor can engage in.
Similar to Swing Trading, some of the more specific trading strategies, such as breakout, reversal, and pullback, can all be sub-strategies of Day Trading. However, under this strategy, instead of examining a security’s price between days, the price must be analyzed between hourly sessions, or even smaller increments, such as every 10 or 15 minutes.
When Day Trading, due to the high volatility that securities can experience in a short time frame, Parabolic SAR can be risky to use unless you scale the indicator setting appropriately. Even then, you must combine Parabolic SAR with other complementary technical indicators to have a better chance of success as a Day Trader.
Several important points of consideration for Day Trading using Parabolic SAR are listed as follows –
- Determining Trade Entry – Like Swing Trading, Day Trading requires you to actively monitor the movement of the Parabolic SAR, and enter trades any time the dots cross the price line to capture the accompanying gains and/or limit losses that will likely come with a potential reversal in price trend.
- Determining Stop Loss Target – The Stop Loss targets with Day Trading must be extremely tight when using Parabolic SAR. This is because if you let a false signal ride, its impact can be catastrophic. As such, day traders must set their Stop Loss at a mere 0.5% below (bullish) or above (bearish) the buy-in price to avoid letting an unexpected retracement undermine any booked profit.
- Determining Take Profit Target – Day traders cannot wait for profits to accumulate, as they make their living by engaging in a high volume of small-profit trades. Therefore, as a day trader, you should collect profits when the price moves 0.5% favorable to your buy-in price.
Trading Strategy 6: Buy-and-Hold Trading Strategy
Buy-and-hold is not an active trading strategy, so Parabolic SAR, as a short-term momentum indicator, may not be necessary when using buy-and-hold tactics. After all, most securities will appreciate in value, given enough time.
While the buy-and-hold strategy most effectively capitalizes on the “time in the market, not timing the market” mindset, if Parabolic SAR is used in conjunction with buy-and-hold, the investor can possibly maximize long-term gains.
Listed below are few pointers to consider when using Parabolic SAR in combination with the Buy-and-Hold Trading Strategy –
- Determining Trade Entry – Buy-and-hold traders do not have to get in as early on a price trend as do traders who engage in more active strategies. As such, as a Buy-and-Hold trader, you may want to wait for a strong parabola to form below the price line (bullish) before grabbing the security and watching the trend take off.
- Determining Stop Loss Target – Buy-and-hold traders do not necessarily have stop-loss in their vocabulary, as they typically ride the wave of market volatility until a security gets to moving in the direction they want. However, time can be the enemy, even to Buy-and-Holders, as significant short-term losses will eat into long term gains. Therefore, as a Buy and Hold trader, you should set a stop loss upon the formation of a strong opposite parabola.
- Setting Take Profit Target – The goal of a Buy-and-Hold trader is to beat the returns of the broader market, which is around 8%. Therefore, any point that falls 8% above the buy-in point may be an excellent time to take the profits from a bullish trade.
Advantages and Limitations of Trading Parabolic SAR
There are no guarantees when trading financial assets. As such, there are no technical indicators that can be perfect tools to accurately predict the future performance of a security and give the go-ahead to change your position.
Parabolic SAR is not immune to this reality. While it is a helpful tool in guiding traders to make informed decisions, it has several drawbacks that must be considered before placing too much weight into its buy and sell signals.
Therefore, in the following sections, let us discuss some important advantages and limitations of trading Parabolic SAR.
Advantages of Trading Parabolic SAR
Listed below are several key advantages of trading Parabolic SAR –
- Buying when the dots are below the price line and selling when they are above it is very intuitive for even the most novice investors. Hence, Parabolic SAR is counted among the simplest to interpret technical indicators.
- The parabolas are clearly distinguishable from the main price line on a chart, causing less confusion than other indicators that are less clear.
- Parabolic SAR can be used effectively with any type of tradable assets, such as stocks, forex, or cryptos, as long as a readable price chart for it exists.
- It can send very strong buy or sell signals to investors when a security is trending strongly in a specific direction.
- The dots give a strong graphical representation of the strength and direction of a price trend. Hence, Parabolic SAR is successful in providing a ton of valuable information in an easy to understand format.
Limitations of Trading Parabolic SAR
Listed below are several key limitations of trading Parabolic SAR –
- Parabolic SAR does not perform well in choppy markets and sends many false signals amid volatility.
- Most trades are losing money when trading Parabolic SAR amid market volatility.
- Solely relying on Parabolic SAR can cause investors to enter a higher number of trades compared to other technical indicators. This is not ideal even if the traders can make a small profit with these trades, as the trading commissions can quickly add up and eat these profits away.
- Parabolic SAR almost always needs to be combined with other complementary tools in technical analysis to improve its reliability and to confirm the existence of a trend.
- It uses a formula that is difficult to manually compute and plot the dots.
- As with almost every technical indicator, Parabolic SAR is a lagging indicator, meaning that it uses precise information on past data to help predict future performance, leading to a variability in the results that it delivers.
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Conclusion
Parabolic SAR (Parabolic Stop and Reverse) is a popular momentum indicator used by technical traders to help identify upcoming changes in a security’s price trend. It is formed by plotting dots above or below a security’s price candles. These dots indicate the strength and the direction of a price trend.
Dots below the price line indicate bullish trends in a security’s price, while dots above the price line indicate bearish trends in a security’s price. This can help investors make informed decisions as to when to change their position on a given security and/or better time their trade entries.
As a short-term momentum indicator, Parabolic SAR performs best when there is a strong trend present in the price of a security. Additionally, as Parabolic SAR has a tendency to break down and send false trading signals in the face of volatility, you should almost always use Parabolic SAR in combination with other complementary tools to improve its reliability and to confirm or reject the existence of a trend.
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