Understanding Indicators

Parabolic SAR Explained

An indicator that uses trailing stops to identify potential reversals in the trend of a security.

Jan 11, 2023

What is Parabolic SAR?

The Parabolic SAR is a technical analysis indicator that helps traders identify potential trend reversals. It is plotted on a chart as a series of dots that are either above or below the price, depending on the trend direction.


Calculation

The Parabolic SAR is calculated as follows:


SAR = SARn-1 + AF * (EP - SARn-1)


Where SARn-1 is the previous period's SAR, AF is the acceleration factor, and EP is the extreme point. The extreme point is the highest high for an uptrend and the lowest low for a downtrend. The acceleration factor starts at a minimum value and increases each period until it reaches a maximum value. The default minimum and maximum values for the acceleration factor are 0.02 and 0.2, respectively, but these can be adjusted to suit the trader's preference.


How is it Used?

The Parabolic SAR is primarily used to identify potential trend reversals. When the dots are below the price, it indicates an uptrend. When the dots are above the price, it indicates a downtrend. When the dots switch from being below the price to above the price, it indicates a potential trend reversal from an uptrend to a downtrend. When the dots switch from being above the price to below the price, it indicates a potential trend reversal from a downtrend to an uptrend.


In addition to identifying trend reversals, the Parabolic SAR can also be used to set stop-loss orders. Traders can use the dots as a guide to set their stop-loss orders, as they will move with the price and trail the trend.


The Pros & Cons of Parabolic SAR


Pros

  • The Parabolic SAR is a simple and easy-to-use indicator that is suitable for beginners.

  • It can help traders identify potential trend reversals.

  • It can be used to set stop-loss orders.

  • It is not affected by the asset's price direction.


Cons

  • It is a lagging indicator, meaning it is based on past price action and may not provide timely signals.

  • It may not be suitable for use in ranging or sideways markets.

  • It can be prone to divergences, which can be confusing for traders.

  • The default settings for the Parabolic SAR (minimum acceleration factor of 0.02 and maximum acceleration factor of 0.2) may not work for all assets or market conditions.


Indicator Pairings for Parabolic SAR

  • Moving Average: The Parabolic SAR can be used alongside a moving average to confirm potential trend reversals. For example, if the dots switch from being below the price to above the price and the moving average is also trending downwards, it is a stronger bearish signal.

  • Average True Range (ATR): The ATR is a technical analysis indicator that measures the volatility of an asset. The Parabolic SAR can be used in conjunction with the ATR to confirm potential trend reversals.

  • Stochastic Oscillator: The Stochastic Oscillator is another popular momentum indicator that is used to identify potential trend reversals. It can be used alongside the Parabolic SAR to confirm potential trend reversals.

  • Moving Average Convergence Divergence (MACD): The MACD is a trend-following indicator that is used to identify potential trend changes. It can be used alongside the Parabolic SAR to confirm potential trend reversals.

  • On-Balance Volume (OBV): The OBV is a volume-based indicator that is used to measure buying and selling pressure. It can be used alongside the Parabolic SAR to confirm potential trend reversals.


Things to Consider

  • It is important to use the Parabolic SAR in conjunction with other technical analysis tools and indicators to confirm potential trend reversals.

  • The default settings for the Parabolic SAR (minimum acceleration factor of 0.02 and maximum acceleration factor of 0.2) can be adjusted to suit the trader's preference.

  • It is important to use the Parabolic SAR in the context of the overall market trend.

  • The Parabolic SAR is typically plotted on the same chart as the price, but it can also be plotted on a separate axis.

In conclusion, the Parabolic SAR is a useful technical analysis tool that can help traders identify potential trend reversals and set stop-loss orders. While it has its pros and cons, it is important for traders to consider the nuances of using the indicator and to use it in conjunction with other technical analysis tools to confirm potential trend reversals.

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