- December 30, 2018
- Posted by: CoachShane
- Category: Trading Article
The Parabolic Sar (stop and reverse indicator) by J. Welles Wilder, is a trading indicator used in markets with a strong trend to determine buy and sell signals for your chosen trading instrument.
The “stop and reverse” feature indicates that the Parabolic Sar is an indicator that was designed to enable a trader to be either long or short – always in the market.
The Parabolic Sar works by plotting dots above and below price which determines your buy and sell signals. The dots rise or fall with price according the indicator setting called acceleration.
The white dots on this chart of crude oil futures, are called a parabola. When the Parabolic Sar plots below price, consider the market to be in an uptrend. When the Parabolic Sar is plotting over price, the market is in a downtrend.
The flipping of the dots are your buy and sell signals.
- The Parabolic Sar has flipped to under the candlesticks on this chart (bullish mode) and that would signal an exit from any short position and be a buy signal
- This is the candlestick that flipped the indicator to the bottom and this would be your trade entry candlestick
- This candlestick has signaled an exit from your long position and a sell signal has been triggered (bearish mode)
Like all technical indicators, the Parabolic Sar is a lagging indicator as it requires a calculation of price in order to plot on the chart.
How Is The Parabolic Sar Calculated?
It is good to have an understanding of the calculation of any trading indicator you will use in technical analysis. By understanding, you will be able to find the nuances associated with each indicator you use.
The calculation of the Parabolic Sar is: SARn+1= SARn + α(EP – SARn)
- SARn is the current period
- SARn+1 is the next period value
- EP equals the extreme high or low value in the current trend
- “A” is the acceleration factor
There are 3 settings for the Parabolic Sar that you can customize although some platforms like Metatrader may only have 2.
- The start value is where the acceleration factor will start at – generally 0.02
- The acceleration factor is how much the original value will increase each time a new high/low in the trend is plotted
- The max value prevents the acceleration factor from increasing too large
When prices begin to move with larger size, the Parabolic Sar begins to plot on a more extreme curve angle as you see on the last up move on the chart above.
Many traders ask about a best setting for trading indicators but the truth is, there is none and the Parabolic Sar is no exception. If you set the acceleration factor too high, the dots will come closer to the price action and you will get quicker buy and sell signals. Quicker signals can equal more whipsaw which is something we do not want as a trader.
There is a trade off between more trading signals and taking more losses.
What Is A Parabolic Sar Buy Signal?
Keeping in mind that there is not a leading indicator that you can put on your chart, but we can use the Parabolic Sar to give us trading signals that we can take or stand aside. Your Parabolic Sar trading strategy, if you choose to use one, should have other variables to indicate whether a buy signal or sell signal is worth putting risk on.
This chart of Natural Gas Futures shows four location where a buy signal would have been offered as a trading opportunity.
When you see the white dots on top of price, we should consider that the market is in sell mode. Once the dots flip to the bottom of the candlesticks, we would consider a buying opportunity.
Trade Entry and Stop Loss Location
The great thing about this indicator is the plotted dots are also stop loss locations. In the inset picture, you can see price has flipped to the bottom which is a buy signal. There are a few ways to enter a Parabolic SAR setup:
- Place a buy stop order at the high of the candlestick that turned the SAR. This will force price to continue moving up to trigger you into the trade with, at least, short term momentum
- You can enter at the close of the candlestick which is perfect for end of day trading (EOD)
- You can set a limit order under the low of the candlestick looking for a short term pullback after the initial change in trend direction as shown by the Parabolic SAR
As part of your trading strategy, you can use the dot feature of the Parabolic SAR for stop loss locations: Calculate the distance from your entry to the dot, calculate your trading risk and position size, and place your stop loss in that location.
Using The Parabolic SAR As A Trailing Stop
Traders know the advantage of trailing stops is that it gives you an opportunity to take from the market what it wants to give you. With profit targets, we are assuming we know what the market is going to do, where it is going to go.
We don’t know how far the market will go and while certain profit targets such as average true range targets are useful, trailing stops can boost your overall returns.
The Parabolic SAR makes it easy to use as a trailing stop regardless of the trading strategy you are using.
In this example, the entry was on the close of the candlestick and the stop would be adjusted daily after each dot was printed.
If you look back at the settings graphic, by adjusting the acceleration factor to .01, there is only one loss instead of 3 but the last long run had more profits given back before being stopped out. As mentioned, there is always a trade off when you make adjustments to any technical indicator so tread wisely.
Can Using The Parabolic SAR With A Moving Average Give Better Results?
Since the term SAR stands for stop and reverse, many traders do follow the indicator in that manner. But is that the best way to trade?
While trading counter trend can be done, there are specific times to do so and for most traders, following the longer term trend is a better way to trade.
Using a moving average as a trend following indicator to show the current trend direction and only taking buy and sell signals from the Parabolic SAR, will likely produce better results.
As with any technical indicator, moving averages rely on the settings you choose as a short term average will change direction more rapidly than a longer term average.
This is a 100 period EMA and the Parabolic Sar on a Forex pair. We can use a simple strategy to enter and exit as such:
- The buy or sell signal candlestick must be above the moving average for longs and below for sell signals
- Only take signals in the direction determined by the moving average – we do not stop and reverse
- We trail using the Parabolic SAR but leave a portion of our position at the original stop location
- Our stop on our remaining position will only move lower for a short and higher for a long, using the new plotted dot
Parabolic SAR and Moving Average Trading Strategy Sample
The following simple trading strategy could be something you test on any market including Forex, Futures and even stocks.
- This is the first time we can take a sell signal as price is below the moving average
- This is our stop position
- Parabolic SAR flips to long and we scale out part of our position leaving the other stop at number 2
- New short setup that we take with entry either on close or break of low candlestick
- Stop from remaining position from the first trade and the stop for the new position being taken
In order to run a proper back test, you will need to use some type of analyzer where you can log in the hypothetical trades and see the result. We have a trade analyzer you can download here and use for free as you go through the trading strategy.
Parabolic SAR For Day Trading?
There is always the question of whether a trading indicator can be used for different styles of trading including scalping and day trading.
As long as you are aware of the drawbacks of using a certain indicator and understand the settings, virtually any trading indicator can be used with any trading style.
What do you consider day trading?
Some traders think day trading is on a lower time frame such as a 5 minute chart. Other traders believe that day trading can be done on higher time frames and you close the trade by the end of the session.
It doesn’t matter if you use the Parabolic SAR for day trading lower time frames or one hour charts closing the position at the end of the session. One thing to consider is using a different setting for the acceleration factor and/or using a different moving average setting.
This is the stock of American Airlines and the solid white line on the left is the opening bell along with a 20 period EMA for trend. After standing aside for 5 minutes, we can start to look for day trading opportunities.
With the Parabolic SAR and moving average strategy, we will only trade in the direction dictated by price relationship to the moving average. If a signal setups up long and the setup candlestick breaks up over the moving average, that is a viable trading signal.
If price does not break the moving average to the upside, we would ignore the buy signal.
- Imagine you use a limit order for a short using the low of the opening candlestick. Since price pokes just below the moving average, it is a sell signal opportunity.
- We get a buy signal opportunity as price breaks the moving average on the setup candlestick. We take a loss on the trade
- The Parabolic SAR gives us a reversal trade sell signal and with our trailing stop loss feature, we ride to a big win at the end of the day
As with all trading systems and trading strategies, risk management is job number one for a trader.
Dynamic Support And Resistance – It’s an Illusion
Some people attempt to sell traders on the idea that moving averages, bands, and even the Parabolic SAR act as “dynamic” support and resistance. They don’t.
When you see price seemingly act as support or resistance, what you are seeing is the result of a mathematical calculation using a variation of open,high, low, close or one of them. If the close, for an example, of price is roughly the same due to a trading range, the moving average will catch up to price.
While it may appear to be acting as a barrier to price, it isn’t. Once you accept that, you may find yourself having a different feeling towards risk management and actual price structure.
Parabolic SAR – A Viable Trading Indicator?
There are some things to like about the indicator especially that it keeps you objective in terms of trade entries.
Using the acceleration factor can help you lock in profits when the trading signal you took is moving in your direction. There is no guesswork involved. If you are thinking of tweaking the settings, often times the default settings are good enough.
There is no best setting to use and you will save yourself a lot of frustration every trying to find one.
There may be other technical analysis tools like candlestick patterns and support and resistance zones that may prove useful for you strategy.
Using a moving average as a trend determination can keep you from getting whipsawed as you will cut down on the buy/sell signals that are plotted. While the stop and reverse feature may attract those who like a lot of trading action, staying with the trend direction for most traders is the best way to go about your trading business.