Master the Parabolic SAR Trading Indicator: Comprehensive Guide in your : Unlock Profitable Trading Strategies

Master the Parabolic SAR: Unlock Profitable Trading Strategies with Trend Reversal Signals - Table of Contents

Introduction to Parabolic SAR

The Parabolic SAR (Stop and Reverse) is a popular trading indicator used by traders to determine the direction of a security’s momentum and the point at which this momentum has a higher-than-normal probability of switching directions. Developed by Welles Wilder, who is also known for creating the Relative Strength Index (RSI), the Parabolic SAR is designed to provide entry and exit points in the market. Its unique feature is its ability to act as both a trailing stop and a method of identifying trend direction, making it particularly valuable for capturing profit during strong trends.

Parabolic SAR Formula & Calculation

The Parabolic SAR places dots, or points, on a chart that indicate potential reversals in the price movement of an asset. These dots are placed below price bars in an uptrend, and above them in a downtrend. The calculation of the Parabolic SAR involves an acceleration factor, which increases as the trend continues, allowing the indicator to “catch up” to prices when the price is moving with strong momentum. The basic formula for the Parabolic SAR is:

For an uptrend: SAR(n+1) = SAR(n) + AF × (EP – SAR(n))

For a downtrend: SAR(n+1) = SAR(n) – AF × (SAR(n) – EP)

Where:

SAR(n) is the current period’s SAR value,
AF is the acceleration factor, typically starting at 0.02 and increasing by 0.02 each time a new EP (extreme point) is established, up to a maximum of 0.20,
EP is the highest high during the current uptrend or the lowest low during the current downtrend.

Parabolic sar indicator - plotted with signals

Interpretation and Trading Signals of Parabolic SAR

The position of the dots relative to the price is key to interpreting the signals from the Parabolic SAR:

Buy Signal: A potential buy signal is indicated when the dots move from above the price bars to below them, suggesting that the downtrend has ended and an uptrend has begun.
Sell Signal: Conversely, a sell signal might be considered when the dots switch from below the price bars to above them, indicating a potential shift from an uptrend to a downtrend.

These signals are particularly clear in visual examples where charts show the Parabolic SAR points flipping positions in relation to price bars during trend changes.

Using Parabolic SAR in Trading Systems

Incorporating the Parabolic SAR into trading systems provides a mechanical approach to entry and exit points:

Trend following systems: The indicator is effective in markets exhibiting strong trends, helping traders stay in positions until the trend exhausts itself.
Combining with other indicators: To filter out potential false signals, the Parabolic SAR can be used with trend-confirming indicators like moving averages or momentum oscillators like the MACD.

The Parabolic SAR often captures trader’s attention because it accelerates upwards (or downwards) as the trend moves up (down). This looks appealing because on the charts it appears to ‘lock in profits’ better than other exit rules such as a chandelier trailing stop or a long term moving average crossover exit.

The challenge, however, is that highly profitable trading relies on letting profits run so you get large winning trades, and cutting losses short. The Parabolic SAR does a good job of cutting losses short, however because it progressively accelerates in the direction of the trend, it does not give a strong trend much room to move. This means if you use this trading indicator as an exit rule you will rarely get very large winning trades as you would expect in a trend following system.

My personal experience has been that Parabolic SAR is much more powerful as an entry trigger than it is as an exit trigger. Using it as a complete system (as it was originally designed) is almost always disappointing.

Adjustments and Custom Settings

Adjusting the settings of the Parabolic SAR can help tailor the indicator to different trading styles and market conditions:

Acceleration Factor: Modifying the AF can make the SAR more reactive or more conservative, depending on whether a trader prefers quicker exits or wishes to give positions more room to breathe.
Max AF: Changing the maximum value of the acceleration factor influences the sensitivity to price changes, accommodating more volatile or more stable markets.

Risks and Limitations of Parabolic SAR

While the Parabolic SAR is a valuable tool for trend traders, it has limitations:

Sideways Markets: The indicator can produce misleading signals in range-bound or choppy markets as the dots may flip frequently without clear direction.
Lag Issues: Being inherently reactive, the Parabolic SAR can sometimes lag behind the current price, especially in fast-moving markets, leading to delayed signals.

Conclusion on Parabolic SAR

The Parabolic SAR is a useful indicator that serves well in trending environments, providing clear signals for stop placement and low risk entry points. It simplifies trade entries, but is not particularly useful as a trailing stop loss exit because it does not give the price trend enough toom to move. However, its effectiveness is enhanced when used in conjunction with other indicators and is most useful as an entry signal to enter a trade after a pullback within an up trend.

Frequently Asked Questions on Parabolic SAR

How accurate is Parabolic SAR?

The accuracy of the Parabolic SAR largely depends on market trends. It performs well in strongly trending markets by indicating potential reversals accurately, but its effectiveness decreases in choppy or sideways markets where it may produce more false signals.

How does the Parabolic SAR indicator work?

e Parabolic SAR indicator places dots on a chart either above or below the price, depending on the direction of the trend. These dots track the price as it moves, with the distance between the price and the dots adjusted based on the price’s volatility, signaling potential trend reversals.

How effective is Parabolic SAR?

Parabolic SAR is highly effective in trending environments as it helps in identifying the end of a trend and the beginning of a new one. Its effectiveness diminishes in non-trending, choppy markets where price direction is unclear and thus may require additional filters or confirmation from other indicators.

How is Parabolic SAR calculated?

The calculation of Parabolic SAR involves an acceleration factor and extreme points. It starts with an initial value and is adjusted in each subsequent period depending on whether the price reaches new highs or lows, thus moving the SAR closer to the price.

How reliable is Parabolic SAR?

Parabolic SAR is considered reliable in trending conditions where it can accurately suggest reversal points and continuation of trends. Its reliability is compromised in ranging markets, leading to potential false signals and misplaced stop-loss levels.

How to set Parabolic SAR?

To effectively set the Parabolic SAR, you need to define the initial acceleration factor and the maximum acceleration factor. These settings can be adjusted based on the asset being traded and the typical market conditions to better align with the strategy’s sensitivity and risk tolerance.

How to trade Parabolic SAR?

Trading with the Parabolic SAR involves initiating trades based on the position of the dots relative to the price bars. A buy signal is generated when the dots shift below the price bars (indicating uptrend), and a sell signal is when they move above the price bars (indicating downtrend). However, it is most effective when used as an entry trigger combined with a traditional chandelier trailing stop because the Parabolic SAR exit signal does not leave much room for day-to-day fluctuations in the stock price, so good trends are often exited prematurely.

How to use Parabolic SAR effectively?

To use the Parabolic SAR effectively, combine it with trend confirmation tools such as moving averages or MACD to filter out false signals. Adjusting the acceleration factor based on the volatility and characteristics of the market can also enhance its performance. The Parabolic SAR is best used as an entry trigger and combined with wider trailing exits (such as a chandelier trailing stop or moving average crossover) to capture large trends.

How to use Parabolic SAR in forex trading?

In forex trading, Parabolic SAR can be particularly useful for setting trailing stops and determining optimal exit and entry points. Since forex markets often exhibit strong trends, this indicator helps in maintaining positions till the trend persists, maximizing profit potential.

What does Parabolic SAR show?

The Parabolic SAR shows potential reversal points in the market by placing dots which indicate the current momentum and direction of the trend. It acts as a visual tool to alert traders when the trend might be changing direction.

What is Parabolic SAR in forex?

In forex trading, the Parabolic SAR is used to determine trend directions and possible reversal points. It is particularly valued for its ability to provide clear entry and exit signals in a market that is well known for rapid price movements.

What is the best Parabolic SAR settings?

The best settings for the Parabolic SAR depend on the market conditions and the trading timeframe. Typically, the initial acceleration factor is set at 0.02 and the maximum at 0.20, but these can be adjusted for higher sensitivity or smoother results. In backtesting we have found that the default settings are frequently the best for this trading indicator.

What does the Parabolic SAR tell you?

The Parabolic SAR provides information about potential price reversals, trend direction, and momentum. It helps traders identify when the current trend is likely to continue or reverse, which is useful for setting up stop-loss points or preparing for market entry.

Is Parabolic SAR Profitable?

Parabolic SAR can be profitable when used as part of a complete, backtested trading system. It is especially useful when used in markets that exhibit strong trending behaviors. Its profitability decreases in sideways markets unless paired with other indicators to confirm its signals. Exit signals from the Parabolic SAR are generally not as useful in isolation as it’s entry signals. We would not recommend using the Parabolic SAR as a complete trading system because this is rarely profitable.

What is the best Parabolic SAR Strategy?

A popular strategy using Parabolic SAR involves combining it with a moving average to confirm trend directions and minimize the risk of false signals, and then us a chandelier trailing stop for the exit. This dual approach helps in reinforcing trade entries and exits based on robust trend confirmation and allows profits to run ensuring a positive expectancy trading system.

What are the disadvantages of Parabolic SAR?

Major disadvantages of Parabolic SAR include its tendency to produce false signals in a ranging or sideways market and its acceleration towards price, which means exit signals do not give stock trends a lot of room to move, thus exiting good trends prematurely.

What is the difference between Parabolic SAR and Supertrend?

Both Parabolic SAR and Supertrend are trend-following indicators, but Supertrend is typically considered to be smoother and less prone to noise. It calculates by combining the average price with volatility, whereas Parabolic SAR is purely based on price movement.

Does Parabolic SAR Repaint?

No, once the Parabolic SAR has calculated and plotted the points for a specific period, these do not change. This attribute makes it a dependable tool for traders who rely on past data for strategy development.

How do I make my Parabolic SAR more sensitive?

To make the Parabolic SAR more sensitive, reduce the step size and the maximum acceleration factor. This adjustment will make the indicator respond more quickly to price changes, though it may also increase the frequency of trading signals and potential false positives.