Introduction to the Parabolic SAR
Using Technical Indicators to Increase Trading Profits
Aug 27, 2008 Richard Mankiewicz
The Parabolic SAR (Stop And Reverse) is an indicator used in the technical analysis of financial markets. It is used as an overlay on your charts, rather than as a separate graph, and signals trend reversals and the locations of stops. The full formula used is a little complicated and will be looked at in the next article, but its key features are fairly straightforward.
Parabolic SAR Behaviour
Imagine the market has touched a key support level and is rallying up from it - you may wish to open this FTSE chart whilst reading this. At some point the SAR will be hit and signal a buy. At the same time it generates a stop loss level below the buy price. What you will see on your chart is that a spot above the price level has flipped to a spot below the market price. This indicates the market is rising and that you should buy into this rally with a protective stop loss at the new SAR spot. Now if the market went up in a smooth straight diagonal line then the SAR levels would form a parabolic curve rising quickly towards the market price. If the price reaches a peak and then trades flat, the SAR stop would also then show a flat line still just below the market price. If the market then comes down it will at some point hit the SAR stop – this is the signal to sell, either closing your long position or opening a short position, or both.
Of course, market prices never move in a straight line and this is reflected in the SAR, but its general feature, that the stop starts to move slowly and then accelerates into the trend, remains valid.
Parabolic SAR Pros
The SAR is useful in that it gives unambiguous buy and sell signals requiring no judgement calls from the trader. If only trading were that simple! Nevertheless, the SAR is good at riding market trends.
Parabolic SAR Cons
One down-side of the SAR is that it behaves poorly when the market is moving sideways within a narrow range. In this case one is likely to see the indicator triggered too late, yielding either low returns or small losses.
The SAR may also give poor results if the market is more volatile than average. In this case the automatic SAR stop is often much further away from the entry point than is prudent. To avoid severe losses from a potential market reversal it is best to place a tighter stop, following the SAR stop only once it is in your favour.
Using the Parabolic SAR
The on-off nature of the Parabolic SAR is both its strength and weakness, and it is best used in conjunction with another indicator, possibly a momentum or oscillator indicator. The SAR can still be used to achieve good entry and exit points but having the trend confirmed by other indicators should reduce the number of bad signals and hence increase profits.
SAR in Real Trading Charts
If you take a look at this FTSE chart, notice that the SAR gave good entry and exit points for the March to May 2008 rally. However, also note the false signal given in the mid-April retracement, which would have resulted in a small loss if the SAR were the only indicator used.
The next article will look at how to change the default parameters to optimise this indicator for different markets.
Money Coins Chart
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