What is the Parabolic SAR (PSAR) Indicator?
Parabolic SAR is a technical analysis indicator. This indicator is used to determine the direction of the price of a stock. In addition to determining the direction of price, this indicator also helps us identify the time when the price reverses from the existing trend. Due to this property, this indicator is aptly named SAR or Stop and Reverse indicator.
Like many other technical analysis indicators, the Parabolic SAR assumes that the trader is fully invested. This indicator creates a trailing stop loss that trails behind the price and guides the investor to move out of the stock if the price breaks through the trailing SAR dots.
This indicator is very useful in a trending market. We will see how this indicator follows the trend and helps the trader to stay invested in the trend.
Why is Parabolic SAR So Named?
J S Wilder first introduced us to this indicator in his famous book New Concepts in Technical Trading Systems, published in 1978. J Welles Wilder created this indicator and named it Parabolic Time/Price System.
The Parabolic SAR indicator follows the price in the form of dots on a chart. These dots sequentially form a curved line. Wilder found symmetry in the curvature of the line with the curvature of the parabolic lines of classical geometry.
Later, seeing the nature of the movement of price in relation to these dots, the indicator was renamed the Parabolic SAR. The SAR is an abbreviation of Stop and Reverse system. The SAR refers to price action.
It must also be mentioned that wilder also created popular indicators like the RSI and the ADX. In the same boo,k we came to know about these indicators also.
How to Calculate Parabolic SAR?
The Parabolic SAR trading strategy has close links with the Parabolic SAR calculation. We will discuss that. This indicator puts SAR or stop and reverse levels on the price chart. The Parabolic SAR calculations are a little complicated and have two parts in the calculation. These two identically different parts are the Rising Parabolic SAR and the Falling Parabolic SAR.
The SAR or stop and reverse levels are calculated from the following formula.
SARCURRENT = PREVIOUSSAR + AF * (PREVIOUSEP – PREVIOUSSAR) (this formula varies in uptrend and downtrend)
Let us explain the terms used in the formula.
AF – AF is the Acceleration Factor. It is a dynamically changing set of numbers that change with every price change. During uptrends, the AF increases by .02, each time a new high is made. But during downtrends, the AF increases by .02 each time the price makes new lows. The AF determines the sensitivity of SAR.
EP – EP stands for extreme point. EP is the highest price of the current trend for an uptrend. In a downtrend, EP is the lowest price point in the current trend.
The calculations differ in uptrend and downtrend. The SAR rises in an uptrend and falls in a downtrend. Therefore, we have the rising SAR and the falling SAR which we are going to discuss now.
The formula for Rising SAR is
SARCURRENT = PRIOR SAR + PRIOR AF (PRIOR EP – PRIOR SAR)
Prior SAR = SAR value of previous period
EP (extreme point) = The highest high of the current trend
AF (acceleration factor) = From .02 at the beginning, it increases by a step of .02 each time a new high is made i.e. EP makes a new high. This continues till the uptrend lasts.
It is to be noted that from the formula shown above, the AF is multiplied by the difference between prior EP and prior SAR. This value is added to the prior SAR to find the current SAR. The SAR can never be above the prior two periods’ lows. If calculation makes the SAR above one of these lows, use the lowest value of the two to calculate SAR.
Shown below are the examples of rising SAR in a chart.
Now, we will see how the SAR values shown in the chart are calculated through a table.
From the table above, you can see we have taken the SAR values on 23rd. and 24th March. We can see how the SAR value increased with new highs in the chart. The uptrend continued till the end and the SAR values increased with every new high made.
The AF remains at 0.20 even though the SAR value is making new highs with the uptrend. The AF value started at 0.02 on 23rd. and 24th. March. The AF value started growing up with new highs, but it never crossed the 0.20 limit.
We will get to see a similar phenomenon in calculations of the falling SAR. This occurs during a downtrend when the price is coming down, making new lows.
The formula for Falling SAR is
SARCURRENT = PRIOR SAR – PRIOR AF (PRIOR SAR – PRIOR EP)
Prior SAR = SAR value of the previous period
EP (extreme point) = The lowest low of the current trend
AF (acceleration factor) = From .02 at the beginning, it decreases by a step of .02 each time a new low is made i.e. EP makes a new low. This continues till the downtrend trend lasts.
It is to be noted that from the formula shown above, the AF is multiplied by the difference between prior SAR and prior EP. This value is subtracted from the prior SAR to find the current SAR. The SAR can never be below the prior two periods’ highs. If calculation makes the SAR below one of these highs, use the highest value of the two to calculate SAR.
Shown below is an example of the Falling SAR in a chart.
Now, we will see how the SAR values shown in the chart are calculated through a table.
From the table above, you can see we took the SAR values on the 20th. and 21st. January. We can see how the SAR value decreased with new lows in the chart. The downtrend continued till the end and the SAR values decreased with every new low made.
The AF never crosses 0.20 even though the SAR value is making new lows with the downtrend. The AF value started at 0.02. The AF value started growing up with new lows, but it never crossed the 0.20 limit.
Interpretation of Parabolic SAR
During an uptrend, the Parabolic SAR follows the price and places a stop just below the price column or price curve. The SAR is a trend-following indicator and it follows the trend. The SAR never decreases in an uptrend. As we have seen in the Rising SAR, the SAR stops increasing in an uptrend. It never decreases and when the price reverses, the Parabolic SAR goes above the price curve, again creating stops in a downtrend.
During the downtrend, the SAR creates stops above the price curve and decreases steadily without moving up. A trader uses the Parabolic SAR as the trailing stop loss to protect profit. Whether in an uptrend or a downtrend, the Parabolic SAR diligently works to protect traders’ profit all the time.
Ideal Settings for Parabolic SAR
The AF or the acceleration factor controls the sensitivity of SAR with the price. A trader can customize the AF to suit his/ her trading style. Adjusting the AF steps affects the rate of change in the SAR.
We have two ways of adjusting the Parabolic SAR. One, we can adjust the step and two, we can adjust the maximum step.
One – Adjusting the step – By default we have the first step at .02 and it increases by .02 at new highs. Now, we can vary it by 0.01, 0.03 and 0.04. The more we increase the step, the more sensitive it becomes. In the chart above, we can see at 0.04, reversals increase and more whipsaws can be there. In this condition, we increase or decrease the step but keep the maximum step at 0.20. The step carries more weight as it influences the incremental stops or rate of increase during a trend.
Two – Adjusting the maximum step – The maximum step can also be adjusted. The adjustment of maximum step increases sensitivity. Lower maximum step decreases sensitivity and there will be fewer reversals if we set the maximum step at 0.10 instead of the default of 0.20.
A trader can adjust the steps and maximum step to increase or decrease the sensitivity of the Parabolic SAR. Sensitivity is equivalent to the rate of change of the SAR indicator.
How to Use Parabolic SAR?
As we found from the PSAR setting, the Parabolic SAR can be adjusted to suit the trading style of the trader. For example, for a normal trader who does swing trading, the default settings, as provided by Wilder himself will suit the trader well.
But for a scalper, more reversals may favour the scalper’s trading technique. Therefore, the trader may increase the AF maximum step to 0.22 instead of 0.20. Else the scalper may choose .03 or above to increase the AF frequency. That will also show more reversals.
Wilder himself found 0.02 is most suitable as the AF step. In his opinion, other steps were not as effective. He recommended the maximum step should fall between 0.18 to 0.22. Beyond this range, he found the settings are not ideally suitable.
Hence, a trader may follow his guideline and use that in creating a trading strategy.
How to Trade Using Parabolic SAR?
Shown below is a price chart of GBPUSD. The Parabolic SAR indicator can be seen as the green dots that are following the price candles. If we watch the chart closely, we will see that whenever the price breaks through the SAR levels, SAR uses it as reversal and the dots are formed on opposite ends of the candles.
During an uptrend, the dots are formed below the price candles. During downtrends, the PSAR dots form above the price candles. Unless the price breaks through the PSAR levels, the dots follow the price diligently. The dots never come too close to price nor do they move far off. Unless the price breaks through, the same format continues.
A trader can use the PSAR in the following ways.
- During an uptrend, the SAR dots form behind the price candles as long as the trend continues.
- Similarly, during a downtrend, SAR dots form above the candles till the trend lasts.
- The SAR should be used as a trailing stop loss, and whenever the price breaches the SAR levels, the trader should move out from the existing position taken along the trend. These are considered as trend reversals.
- A trader may enter a trade when price breaks through the SAR levels and starts a new trend.
Trading Strategy with Parabolic SAR
Wilder, in his book New Concepts in Technical Trading Systems, recommended using the Parabolic SAR indicator along with the ADX indicator to find the most effective results.
Trade using Parabolic SAR indicator with ADX
With the use of the ADX indicator, we can be assured of the trend and can also find trading signals. As the PSAR indicator is not very effective in a trading market, a trader should make sure of the trend before entering a trade using the Parabolic SAR indicator.
Here we have used ADX, +DI and -DI to remain assured of the trend and also the trend strength.
In the chart below, both the buy and sell signals are found using the ADX.
Buying with Parabolic SAR indicator
A trader should buy when the ADX is above 20 and the +DI indicator is greater than the -DI indicator. Also, the SAR dots should be below the price candle.
Selling with Parabolic SAR indicator
Create a short position when SAR dots are above the price candle, ADX is above 20 and -DI is greater than +DI.
In the chart above we can see how the buy and sell positions are created. The trade confirmation given by the ADX indicator makes the strategy doubly effective.
The Parabolic SAR indicator is an effective indicator that provides steady trailing stop signals to help a trader who is already invested all along the trend direction. Unless the trend is broken the SAR dots steadily follow the price candles till the trend lasts.
If a trader wants to trade using the PSAR indicator, ADX indicator must be used to find trading signals. The trading style may need the trader to adjust the sensitivity of the SAR indicator.
In a trending market, the price falls within the parabolic curve of the Parabolic SAR indicator as long as the trend continues. If the price comes out of the PSAR curve, the trend reverses.