Parabolic SAR, or parabolic stop and reverse, is a technical analysis tool developed by the prolific J Welles Wilder. It is a common tool on many trading platforms and can be used for stocks, forex, options and futures.
It shows itself as a series of dots that are under the candlesticks in an upward trend and above them in a downward trend. Each dot represents a potential reverse in pricing behaviour.
Parabolic SAR is used to tell when a trend has changed direction as the dots will move from above the candlesticks to below or vice versa.
When the dots move below the candlesticks this signifies the start of an uptrend and is a cue to buy; dots switching to above the candlesticks indicate the start of a downtrend and this is therefore a cue to sell or short sell.
One of the uses of the parabolic SAR is the positioning of stop loss orders. Rather than putting a stop loss order just below the price that a long position was taken out at or just above a short position’s original price, a trailing stop can be based on the parabolic SAR line.
Thus the point when the stop loss order comes into play will increase with a rising price on a long position and decrease with a falling price on a short position.
This versatility means that profits can be locked in.
Parabolic SAR does have its limitations, though. It works best in markets that have clear trends. In a sideways market the dots will tend to bounce up and down in an unhelpful way, giving constant trade signals and false indications.
While the parabolic SAR is good at indicating the change of direction of a trend, it does not show how strong that trend is. For this reason it is better to combine it with another indicator.
Welles Wilder recommended using it together with the average directional index or ADX. This index shows the strength of a trend, while its two accompanying lines show the direction. The DI+ line is the positive direction indicator and the DI- line shows negative movement.
So once the dots have moved below the candlesticks you would also look for an ADX reading of more than 25 (this level indicates a trend worth investigating) and for the DI+ line to have crossed above the DI- line before you invest.
And conversely, once the dots have positioned themselves above the candlesticks, before selling or going short you would check the strength of the ADX reading and see if the DI- line had crossed above the DI+ line.
Another indicator that can be combined with the parabolic SAR is the simple moving average or SMA. This averages out closing prices over a set time, often the preceding 50 trading days.
So if the dots are below the candlesticks and the price is below the SMA the trend is likely to be bullish.
And if the parabolic SAR is showing a downward trend and the price is above the SMA, indications are that the trend is likely to become bearish.
The efficacy of using parabolic SAR has been examined by a couple of academics from the University of Houston.
Pistole and Metghalchi compared trading using a variety of technical indicators against a simple buy-and-hold strategy for the S&P 500.
They looked at data over 17-year and five-year periods to test how the indicators worked over different timescales.
They concluded that: “Results over the long and short terms show that by using the Parabolic SAR as the buy and sell signal, a trader will significantly outperform the market.”
Due to the simplicity of its graphics, parabolic SAR gives easy to follow buy and sell signals and is a useful way of determining where to place stop loss orders.
While it is of limited use in a sideways market, when the market is moving it can be combined with other technical indicators to be a helpful way of optimising your trading returns.