The Parabolic SAR (Parabolic SAR) is another of the technical stock market indicators developed by the legendary Welles Wilder, who published it in his mythical book “New concepts in technical trading systems”, together with the RSI, the ATR and the ADX.
Wilder called this issue something like “Parabolic time price system”, although SAR would come to be “stop and reverse”. This is because the indicator tries to give us signals of when the trend changes, hence the term “reverse”.
What type of indicator is parabolic SAR?
It is a trend indicator because it tries to give us the approximate points of when a trend is coming to an end. It meets its objective quite well because in many cases it gives us a fairly clear picture of when an important trend ends or starts, although also, like all indicators, it gives us lots of “errors”.
Therefore, since it is an indicator that follows the trend and its changes, it could be useful for those of us who use trend systems in trading.
How is parabolic SAR calculated?
This indicator is quite cumbersome to calculate although you do not need a master’s degree in engineering to do so. Only we will have to take different prices and data and add them and subtract them in the subsequent equations.
In general, we will calculate SAR for when it goes up and when it goes down.
When parabolic SAR goes up we would have something like this:
- Previous SAR
- EP (extreme point) which is the highest price in the current trend.
- AF, which is the acceleration factor, which starts at 0.02 and increases by 0.02 each time a new maximum is made, until reaching 0.20, a point that cannot be exceeded.
- Current SAR = Previous SAR + Previous AF (Previous EP – Previous SAR)
When the SAR goes down we would have something similar but the other way around:
- Current SAR = Previous SAR – Previous AF (Previous SAR – Previous EP)
As you can see very simple, right?
Well, knowing how it is calculated in an approximate way is fine but what really interests us is knowing how it is used and if it can give us an advantage when it comes to getting some edge in trading or investing in the stock market.
Parabolic SAR as a trailing stop?
There are many who speak of the Parabolic SAR application efficiently as a stop loss order, which in the case of this indicator would work as a trailing stop, that is, a stop that goes up or down as our trend continues and that would only be executed if the trend ended.
The truth is that it is a good point of view, because if we look at the graphs in which we use this indicator, especially the daily or weekly charts, many of the major trends run for a long time without the price touching that trend, which can eventually give us great profits, once the price is around, touch the SAR and we decide to leave.
How to use parabolic SAR?
If you noticed, you saw how I named the “weekly charts” in my previous point.
How far is that from the much loved and sought after graphics of 5 and 15 minutes by all those hordes of day traders?
Yes, it’s far away, but for us it is better that way.
If we use the weekly chart, we can sometimes find large movements in our favour, as we can see in the following chart.
In the same the DAX rose more than 20%, but since the SAR began, with the closure of the first bar with positive SAR, until the price touched that indicator, we had a good opportunity to do bullish trading.
As you can see, in that period you only want to trade up, because trying to play down is not a very good idea so to speak.
However, do not get excited so quickly, because in that same weekly chart, with such a good opportunity to trade on the upside, we also have many other examples of how we can get into complicated territory when trading with this indicator.
The problem is that when we enter side or lateral markets this – and others – indicator gives us a huge headache – if following its “trend signals” of course.
For example, we can see how in the months of October and November we had a clear “signal of sale” with the SAR.
However, as we see there, since the first bar closed with a parabolic SAR of “sale” until the next one opened with a “buy”, which occurred the week of November 17, we had a horrible streak, in which despite having signals of shorts, the DAX rose by 7%, which would have been a trade, or quite disastrous trades, no doubt.
Here the best thing would have been to go bullish, right?
Yes, but is not the SAR supposed to measure the trend and its ending point? How is it possible that it fails like this?
Because, like all trend indicators, it gives wrong signals when we find ourselves in side markets, which I have already said before, are the “trader’s nightmare”. For brokers or dealers, however, they are a blessing.
How to solve this?
Many people think that the best way to solve the problem is by going to the minor temporalities where the SAR is sure to be able to find the trends in a more precise way, like 1, 4 hours or daily bars.
The last point is true, no doubt, but it is also true that we will find many more short side markets that will be equally problematic, so we can never escape this trap altogether.
My advice here is that we always keep at least the daily charts or as little as 4 hours, without going further, because for the trader at the end will be the best, especially for those who do not have much experience.
However, I’m sure you still want to do day trading with Parabolic SAR.
Parabolic SAR for day trading?
Let’s see some example of how Parabolic SAR can behave in 15-minute candle trading, very typical of intraday trading.
This graphic belongs to three random sessions of the DAX 30.
In the same we can see how five possible signals we had 4 very bad ones in which the price went in the opposite direction to which supposedly the SAR would have indicated us.
This is a clear example of “intraday side market”, which always gives us problems when the indicator is doing “lagging”, that is, goes behind the movement, something consubstantial to the terrible “side market”.
Does that mean then that we have to do intraday trading with Parabolic SAR?
Not so fast.
Because likewise that this type of indicator gives us bad signals when the market starts to rise and fall like a yoyo, it also gives us excellent signals when the market is moving strongly in one direction.
In the following example we can see how when the movement is strong enough in one direction, in this case 3% in the DAX, the parabolic SAR holds up very well and gives us two perfect signals followed by buying and selling in which the DAX 300 points were moved in each one.
How confusing is not it?
Well, if you really want to know if this works well in day trading, you should apply it to the instrument that interests you most and look for profit and loss objectives, as well as the configuration you want to apply to the indicator, because obviously it does not have to be in increments of 0.02, because it can also be 0.01, 0.04 or any other number that you can think of.
Once you are clear about what you want to do, you can carry out some small “manual tests”, or better yet, an automated test using some of the market possibilities and see what you can pretty much get out of this indicator.
Parabolic SAR and the moving average
If you have experience in trading you will have noticed that this indicator is very similar to the moving averages, since both measure the trends and the changes of these in a similar way so that we could almost use one or the other and obtain similar results.
I personally like the mobile average more, but only because of how it looks in the graph, from my point of view in a more “clean” way.
The parabolic SAR is one of the most useful indicators that can be found in the wide repertoire of trading indicators.
Sometimes it can give us spectacular signals of important trends, but it also presents us with many problems in range or lateral markets.
Before using this indicator we should try to find a particular way of trading.
We must look for our way, and for that we will have to look for the way in which we are going to enter and leave each operation, what risk we are going to assume and many other things.
That is, we will need a trading plan that will serve as a basis and with it we can try to find the way to use parabolic SAR in some way that could be advantageous.
For example, most technical analysis experts say that SAR gives us an excellent trailing stop on our possible operations.
Well, I say that it is better to try to “anticipate” those “trailing stops” of the SAR, but for that we will have to use some particular trading techniques.
Anyway, I encourage you to study this indicator and try to put it into practice in demonstration accounts or simulations of any kind.
Greetings and good trading.