Parabolic SAR indicator: The ideal stop loss?

Trend indicators

Parabolic SAR indicator
  • The Parabolic SAR indicator helps traders spot trend direction and potential reversals.
  • It appears on charts as a series of dots/cross above (when price is going down) or below (when price is going up) security’s price.
  • It’s mainly used as a trailing stop.

What is the Parabolic SAR indicator?

The Parabolic SAR Indicator is a technical indicator that uses a trailing stop and reverse method called “SAR”, or stop and reverse to locate the appropriate entry and exit points. J. Welles Wilder created it. the indicator is used by traders to identify trend direction and likely reversal in price. The Parabolic SAR Indicator helps forecast the price direction of an asset. It also helps notify the traders during an event of price direction changing.

The SAR Indicator appears on a chart using various dots above or beneath the price bars. Some traders consider a dot beneath the price as a bullish signal. On the other hand, a dot above the price shows that the bears are in control and also that the momentum is potentially going to remain downward. 

When the dots flip, it signals that a likely change in price direction is imminent. For instance, if the dots are above the price when they flip below the price, it could indicate an additional increase in price.

When the price of an asset increases, the dots will also slowly increase initially and later pick up pace, accelerating with the trend. The SAR starts to move a little faster as the trend progresses, and the dots soon catch up with the price.

How to use the Parabolic SAR?

Making use of Parabolic SAR as the only indicator can often lead to entering/exiting a position prematurely. And for this reason, many traders will choose to place their trailing stop loss orders at the SAR value. This is because a single move beyond this will indicate a reversal, making the trader to expect a move in the opposite direction.

The Parabolic SAR in a prolonged trend is usually far enough removed from price. This happens so as trader can avoid getting stopped-out of a position on temporary reversal of trend. The temporary reversal happens during a long-term trend. It allows the trader to remain in the trend for a lengthy time and benefitting huge profits.

Traders can easily locate where a trend ends, just as they can spot new trends. Here is where the Parabolic SAR comes in as it is capable of identifying where a trend might end. Hence, the name Parabolic SAR (Stop And Reversal). 

It is really easy to make use of the Parabolic SAR Indicator. Whenever the dots are beneath the candles, that would denote a buy signal and when they are above the candles, it would denote a sell signal. This indicator is so easy to understand and interpret as it predicts that the price is either climbing up or down.

Calculations for Parabolic SAR

Parabolic SAR uses values of previous period to produce new calculations. The calculation also would either be based on a rising or falling SAR.

Rising Parabolic SAR

Basically, there are three elements: the prior SAR, and two indicator-specific values: the extreme point (EP) and acceleration factor (AF).

  • Prior SAR equals the SAR value of the previous period 
  • Extreme point (EP) equals the highest high of the prevailing uptrend

Acceleration factor (AF): with the indicator’s default settings, commences at .02 and increases by 0.02 each time the extreme point (EP) makes a new high. Its highest value is 0.20 regardless of the number of new highs the extreme point makes.

The current SAR value calculates by adding the prior SAR to the product of the prior acceleration factor and the difference between prior extreme point and prior SAR.

Current SAR = Prior SAR + Prior AF * (Prior EP – Prior SAR)

Falling Parabolic SAR

The three elements are still the same: we use Prior SAR, Extreme Point (EP), and acceleration factor (AF)

Current SAR = Prior SAR – Prior AF * (Prior EP – Prior SAR)

Limitations of the indicator

Limitations is not symbolic to Parabolic SAR Indicator alone, but rather common even among all other types of indicators. The Parabolic SAR Indicator is capable of leading to false signals when the price goes sideways. It can also lead to false signals when trading in a choppy market. This indicator would have kept the trader in trade while the price rises. 

As soon as the price moves sideways, the trader should definitely be expecting more losses or just very little profit. And if we look closely enough, the Parabolic SAR makes this error because it is built only to determine and read prices moving upwards and downwards. And as such, it is not able to deal with price going sideways.

It is best to pair the Parabolic SAR with other indicators like ADX, moving average or the stochastic indicator. This is the best way to bridge this limitation.

Also the Parabolic SAR works best in a market that has a steady trend. But in a ranging market, the parabolic SAR will whipsaw back and forth, leading to false trading signals. 

The Parabolic SAR is always on and always generating signals, either in the presence or absence of a quality trend. And as such, many signals may have bad quality because no significant trend is available or develops following a signal.

Conclusion

It helps traders track trends

Parabolic SAR is regularly used to track trends. It is also used to direct traders as to where they should place their stop-loss. This is important so they can limit the downside and protect the profit tied with their trades. The progressive dot configuration of the indicator works in a similar way to the adjustment of a trailing stop. The settings of the indicator can be adjusted from its step and highest value of .02 and .20 respectively.

If you intend to decrease the sensitivity of the indicator, have sporadic changes in the trend and looser trailing stops. Also, the step and maximum value should be decreased. Increase the step and the maximum value to increase the sensitivity of the indicator. Doing this will led to more frequent changes in the trend as indicated by SAR, and tighter trailing stops.

You can access the settings on a security platform and in the direction of your trading choice. There is no correct way to determine which is best. People use the default settings less frequently. 

It’s better when used in conjunction with other indicators

Traders are always advised to never use the Parabolic SAR alone, just as it is with all other indicators. There are many modes of analysis to be used to come up with a complete trading system. You can observe the price action or other technical indicators and fundament analysis. 

Based on Wilder’s estimate, the Parabolic SAR works best with trending securities, which happens roughly 30% of the time. This means that this indicator would be prone to whipsaws for over 50% of the time. This can mostly occur when a security is not trending. Don’t forget that SAR was designed to jump on trend and follow after it like a trailing stop. 

The signal quality depends on the settings and the properties of the existing security. The appropriate settings mixed with decent trends will produce a brilliant trading system. The wrong settings will lead to whipsaws, losses and regrets. There is not rule of thumb or one size-fits-all setting for this. All the security should be examined based on their properties.

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