Technical analysis has existed for centuries, but it was only in the last few decades that technical indicators have become so widely used. The advent of integrated circuits in electronic computers made calculations effortless and more complex calculations faster.
What Is the Parabolic Stop and Reverse (PSAR) Indicator?
In the late-1970s, technical analyst J. Welles Wilder Jr. developed the Parabolic Stop and Reverse (PSAR) indicator, publishing it in his book, ‘New Concepts in Trading Technical Systems.’ The book also defined other popular indicators, such as the Relative Strength Index (RSI) oscillator.
It also described the PSAR strategy as the Parabolic Time/Price System, with SAR being the point at which traders exit long-trades and enter short-trades or vice versa. Today, it is known around the world as the parabolic SAR indicator and is used to identify trends, reversals, and breakouts.
How to Use The PSAR Indicator?
The parabolic SAR highlights the direction of an asset’s price action and shows traders entry and exit points they can use to profit. The indicator appears on the chart as a sequence of dots running above or below the price, depending on the indicated trend. A dot underneath a candle is generally a sign of an uptrend, and a dot above the candle can signal an incoming bearish movement.
When the price of an asset climbs, the dots follow alongside, accelerating with the trend’s momentum as it draws closer to the price. However, the dot flipping sides isn’t a guarantee of profit. While the parabolic SAR works well for snagging gains during a steady trend, it often produces false signals in ranging and consolidating markets.
Set Stop-Loss Orders
Traders also use the parabolic SAR to set stop-loss orders, moving the stop to match the indicator when the stock rises or falls. It’s also known to follow the broader trend, and traders strictly sticking to a parabolic SAR strategy can often miss smaller opportunities within these trends.
However, most traders advise only trading the parabolic SAR in the dominant trend’s direction. Using tools like a moving average can help filter out some of the less reliable signals. Sell signals from the parabolic SAR are much more reliable when an asset trades under a long-term moving average.
This suggests sellers are in control of the price action and likely implies further depreciation. Similarly, buy signals are much more reliable when the price trades above the long-term MA. While the parabolic SAR can still be used to set stop-loss positions, taking short positions during longer uptrends isn’t a great idea.
Can You Profit from the Parabolic SAR Strategies?
One criticism of parabolic SAR strategies is the number of trades they create. Some traders even argue that indicators like moving averages can cover the same profit windows through fewer transactions. For this reason, the parabolic SAR is mostly used by more active traders looking to profit from momentum.
A study conducted at the University of Houston – Victoria tested a simple moving average strategy and a parabolic SAR strategy against a buy-and-hold strategy across 17 years of the S&P 500’s price data. While the SMA method results weren’t all too impressive, the parabolic SAR approach demonstrated statistical significance at a 95% confidence level.
Not only did this fly in the face of buy-and-hold theorists, but it also contradicted the beliefs of efficient market theorists. Rest assured, the parabolic SAR is no game-changer, but it’s certainly an integral part of any trader’s toolkit. Besides assisting in finding trend direction and reversals, it can also help detect the trend’s momentum. While its signals can ring false at times, it continues to provide traders with a reasonable degree of reliable signals to profit from.
Parabolic SAR Formulas
The PSAR is calculated differently for rising and falling market movements and uses a variety of metrics to do so. Some traders create spreadsheets with price highs and lows, recent extreme prices (EP), and acceleration factors (AP) tracked periodically to calculate the indicator manually, but most modern charting software calculate the parabolic SAR automatically.
This makes the PSAR surprisingly accessible despite its intricate inner workings. Traders only need to know how to interpret its signals and often use the indicator to mark trailing stop loss orders for potential exit points on long assets. In some cases, it can even help prevent traders from closing profitable investments or entering trades too early.
The parabolic SAR isn’t as reliable when no trend is observed. Even in markets where the price rises before consolidating, the PSAR continues increasing while the price moves sideways. When the parabolic SAR eventually reaches the price, the generated reversal signal can throw off even some of the most careful traders.
Each time the PSAR crosses the price, it generates a new signal, and while this is great for active traders because it’s perpetually signaling a position, this isn’t as effective in markets that aren’t trending. Traders usually recommend using the parabolic SAR with indicators that detect trends like the average directional index (ADX), a trendline, or a moving average.
The Parabolic SAR and Moving Averages
Both the parabolic SAR and moving averages track the price and trend direction, but they do so differently. Where MAs calculate the average closing price of an asset over an interval of time, the parabolic SAR observes extreme highs and lows and applies an acceleration factor. They also appear different visually on a chart and provide separate insights and signals.
Since the parabolic SAR provides a signal every interval, regardless of whether a market is trending or not, many of its alerts aren’t too reliable, especially in markets with no prevalent trend. Moving averages, on the other hand, create signals less frequently and are guided by price-based events.
The parabolic SAR is calculated by multiplying the difference between the prior SAR and the extreme price with an acceleration factor, and adding or subtracting the previous PSAR value based on whether the market is trending up or down. The extreme price is determined by the highest high for uptrends and the lowest low for downtrends, and is updated each time it is breached.
Since the PSAR calculation relies on its previous values, Wilder himself recommends drawing the first value from the most recent extreme price before a trend reversal. The default acceleration factor used is 0.02, and this value increases each time the extreme price is updated up to a maximum of 0.2.
Essentially, the parabolic SAR accelerates towards the market price, and its impatience places a premium on time. As each interval passes, the PSAR moves closer to the price, making it easier to trigger a shift in the trend’s direction and test whether the price can maintain its momentum.
Traders don’t always use the indicator’s default settings, with acceleration step size being a critical parameter in determining the parabolic SAR’s sensitivity. The maximum acceleration can also be altered to impact sensitivity, but its effects occur much later and more significantly for longer price swings.
Hopping on the Trend
The parabolic SAR is one of the most accepted indicators in the trading world, and while it does give the occasional false signal, it’s far from unreliable. Combined with other indicators, the PSAR gives traders a better idea of where the trend is going and where to enter and exit.
EMA Crossover and Parabolic SAR Strategy
Traders also consider the exponential moving average (EMA) crossover with the parabolic SAR for marking entry and exit points. The PSAR provides information on trend direction, but since it does not consider volume into its formulae, the indicator doesn’t offer as much clarity about a trend’s strength. While the gaps between the dots may widen as the price moves up or down, this doesn’t necessarily guarantee a strong trend.
However, by using two PSAR indicators, traders can get accurate signals even in ranging and consolidating markets. With one PSAR to gauge the trend and a second to mark entry and exit points, a double parabolic SAR strategy operates on two different timeframes. The longer time frame tracks the overall trend, while trades are made based on signals from the shorter SAR.
A double PSAR strategy can also be executed using two parabolic SAR plots at different sensitivity levels on the same chart timeframe. The less sensitive indicator detects trends, while the more sensitive one triggers trades, similar to a dual-MA strategy.
Some investors also use a supertrend indicator, which extrapolates the average true range (ATR), to confirm the trend signaled directly by the PSAR. The ATR is a volatility indicator that compares the highs and lows of an asset’s price action to produce a number added or removed from the closing price to determine entry and exit prices.
However, while the supertrend’s extension of this calculation can help confirm existing signals, it’s often slower to alert traders that the PSAR itself. According to Wilder, assets trend 30% of the time, making the parabolic SAR less dependable in more than half of the cases when the asset’s price fluctuates wildly or doesn’t trend at all.
Signal quality can vary with settings and the underlying asset itself, and while the wrong settings can lead to disastrous losses, the right ones can lead to some timely profits. Every investment strategy comes with risks – that’s just how financial markets are, and it’s important to temper expectations of how successful a particular method could be.
That being said, research shows the parabolic SAR is not entirely discountable, and its ability to provide quick, consistent signals can be precious in trending markets. Though not always accurate, the parabolic SAR is a unique technical indicator that has stood the test of time and will probably continue to do so for the foreseeable future.