The parabolic stop and reverse (parabolic SAR) indicator was developed to help traders locate buy and sell signals for current trends and determine when to enter and exit trades based on an asset’s momentum. It was created by J. Welles Wilder Jr., a prolific mechanical-engineer-turned-analyst who pioneered a variety of the technical analysis tools that financial traders still rely on today. His other feats include the relative strength index (RSI), average directional index (ADX), and average true range (ATR).
Identifying Parabolic SAR Trends
The parabolic SAR is plotted directly onto a price graph and appears as a series of dots that snake above and below the price candlesticks. When the dots move below the price, it’s considered to be a bullish (buy) signal. Conversely, when the dots move above the price, it’s regarded as a bearish signal indicating that momentum is likely to remain in a downward trend that favors sellers.
When a change in market momentum occurs, the dots will cross over from one side of the price bars to the other. Because changes in market momentum often precede changes in price, this flip is considered to be an indicator that a trend reversal is imminent.
In addition to dot position, dot spacing is also revealing. At the beginning of a new trend, the parabolic SAR dots will start close together and spread further apart as momentum accelerates and the trend fully develops. As momentum slows, the parabolic SAR will catch up to the price, and the dots will once again become more compressed.In the image below, the parabolic SAR crosses over the price bars, producing a sell signal.
As the new trend starts to form and momentum accelerates, the dots spread out and then draw closer again as they approach the next crossover.
Advantages and Risks of Using the Parabolic SAR Indicator
The biggest benefit of the parabolic SAR is that this indicator illustrates the strength of a trend as it’s taking place. Once you open a position, the strength of the trend can help you determine whether to stick to your position or close it out.
The parabolic SAR has exceptional value in helping you time your exit when trying to maximize your profit from any given position. At the same time, weakening trends don’t always lead to reversals, so timing trades based on these slowdowns can lead you to miss out on additional profits that other indicators might have convinced you to patiently wait for.
In addition, parabolic SAR’s usefulness is directly tied to the momentum of a given price movement. But in cases where trends aren’t strong, the parabolic SAR doesn’t offer much value, making it an unreliable tool in some situations. Without strong price trends, you’re better off basing your strategy on other indicators.
When to Use the Parabolic SAR
The parabolic SAR operates on the premise that a price is always trending up or down and never stagnating. For this reason, it’s ideal for trending markets that oscillate between high and low periods but maintain a diagonal trajectory. To identify a trending market in forex, look for a price movement that starts in the upper left-hand quadrant and moves diagonally down to the right, or vice versa, as illustrated by the graph below:
Keep in mind that the parabolic SAR is a lagging indicator. In other words, it starts slowly, gains momentum with the trend, and often lags behind the price. All lagging indicators are prone to creating false signals and thus favor trend-following strategies that can withstand smaller market stop-outs.
The image below highlights an instance in which the parabolic SAR would have kept a trader in a position even as the price rose against him. Though the parabolic SAR eventually catches up and crosses over in accordance with the trend, the trader should expect smaller profits or more losses if the price continues to fall in a sideways fashion. When the market is in a strong trend, as indicated by the more precipitous falls in price and more widely spaced dots, the trader is more apt to benefit.
When Not to Use the Parabolic SAR
The value of the parabolic SAR is directly tied to the strength of its trends. When this indicator illustrates strong trends for a currency pair, it’s a great tool that can guide your decision-making, especially in a volatile market. But when market conditions are stable or price movements aren’t showing strong momentum, you’re better off using other tools to evaluate trade options—the parabolic SAR might lead you into positions you later regret.
Using the Parabolic SAR in Conjunction with Other Indicators
Combining the parabolic SAR with other momentum indicators that gauge a trend’s strength will help you determine when to enter and exit trades to incur the least amount of risk. Wilder used the parabolic SAR in conjunction with his ADX to confirm a trend’s direction and momentum before entering or exiting a position.
In addition, indicators that use moving averages, such as moving average convergence divergence (MACD) and Bollinger Bands, can be used to confirm the buy and sell signals that manifest during parabolic SAR crossovers. The same is true for the ATR, which can help you measure market volatility to evaluate not only the potential price movement driven by a trend, but also whether the current market conditions are properly served by the parabolic SAR.
Lastly, the RSI can be a reliable tool for corroborating trends based on whether overbought or oversold conditions are present—which can be a significant driver of trending movement. As with all trend-following strategies, discretion is rewarded more frequently than haste.
The parabolic SAR isn’t an indicator to rely on in every trade analysis, but it can be an excellent tool for both identifying trends and maximizing your reward for staking a position that profits off these swings.
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