The parabolic SAR is a technical indicator used to determine the price direction of an asset, as well as draw attention to when the price direction is changing. Sometimes known as the “stop and reversal system,” the parabolic SAR was developed by J. Welles Wilder Jr., creator of the relative strength index (RSI).
KEY TAKEAWAYS
How Parabolic SAR works
The Parabolic SAR is usually represented in the chart of an asset as a set of dots that are placed near the price bars. Generally, when these dots are located above the price, it signals a downward trend and it is deemed to be a sell signal. When the dots move below the price, it shows that the trend of the asset is upward and signals a buy.
The change in the direction of the dots produces trade signals which can produce a profit when the price makes big swings. However, the indicator is not as reliable in a flat or ranging marekt.
How to Calculate the SAR Indicator
The Parabolic SAR uses the highest and lowest price as well as the acceleration factor to determine where the SAR indicator dot will be displayed. The formula for the Parabolic SAR is as follows:
Uptrend Parabolic SAR = Prior SAR + Prior AF (Prior EP – Prior SAR)
Downtrend Parabolic SAR = Prior SAR – Prior AF (Prior SAR – Prior EP)
Where:
- EP is the extreme point in a trend (highest point reached by a price during an uptrend or the lowest price reached during a downtrend).
- AF is the acceleration factor which is initially set to a value of 0.02 (it is increased by 0.02 each time the EP is recorded, with a maximum of 0.20). Traders can choose the acceleration factor depending on the tradings style or instrument being traded).
Conclusion
The Parabolic SAR works best with trending securities, which occur roughly 30% of the time according to Wilder’s estimates. This means the indicator will be prone to whipsaws over 50% of the time or when a security is not trending. After all, SAR is designed to catch the trend and follow it like a trailing stop. As with most indicators, the signal quality depends on the settings and the characteristics of the underlying security. The right settings combined with decent trends can produce a great trading system. The wrong settings will result in whipsaws, losses, and frustration. There is no golden rule or one-size-fits-all setting. Each security should be evaluated based on its own characteristics. Parabolic SAR should also be used in conjunction with other indicators and technical analysis techniques. For example, Wilder’s Average Directional Index can be used to estimate the strength of the trend before considering signals.
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