The Parabolic SAR Indicator

Overview and Definition

The Parabolic Stop and Reverse (SAR) is a trend-following indicator developed by J. Wells Wilder. It is also known simply as Parabolic SAR, "just parabolic," or PSAR.

The indicator follows a parabolic arc and is primarily used for two purposes:

  • Identifying the underlying trend direction.
  • Functioning as a trailing stop technique for money management.

Calculation Components

The PSAR uses two key variables to determine future points on the parabolic arc:

  • Extreme Price (EP): This is the most recent extreme price. It corresponds to the highest high reached during an uptrend or the lowest low reached during a downtrend.
  • Acceleration Factor (AF): This factor determines how quickly the SAR approaches the price.

The PSAR Formula

The calculation is based on the previous day's SAR, the EP, and the AF:

SAR (Current) = SAR (Yesterday) + AF × (EP - SAR (Yesterday))

Acceleration Factor Details

The AF is dynamic and updates whenever a new Extreme Price (EP) is reached:

  • The default starting AF is 0.02 (2%).
  • It increases by 0.02 (2%) each time a new EP is reached.
  • The AF typically has a maximum cap, usually set at 0.20 (20%).

Market Interpretation

The SAR is plotted as a dotted line above or below the price. The trend is determined by the position of the price relative to the SAR:

  • Bullish Trend: The price is above the SAR.
  • Bearish Trend: The price is below the SAR.

The Stop and Reverse Mechanism

The Parabolic SAR starts relatively far from the price and accelerates toward it as the trend continues. When the price touches the SAR, a stop and reverse signal is generated.

1. Uptrend Operation (Long Position)

  1. When the price crosses above the SAR, a long position is entered. A new SAR dot is placed below the prices, usually at the level of the recent low.
  2. As the uptrend advances, the SAR rises and accelerates, closing the gap between itself and the price action.
  3. The SAR continuously protects profits by acting as a trailing stop.

2. Downtrend Operation (Short Position)

  1. When the price crosses below the SAR, the existing long position is closed (stopped), and a short position is entered (reversed). A new SAR dot is placed above the prices.
  2. As the downtrend continues, the SAR drops and accelerates, closing the gap between itself and the price action.
  3. When the price touches the SAR again, the short position is closed, and a long position is entered, reversing the trend once more.

Applications and Limitations

The Parabolic SAR is considered a complete and disciplined trading system by many users:

  • It serves as an excellent trailing stop loss technique, allowing profits to run while minimizing losses upon reversal.
  • It provides clear entry and exit signals.

Limitation: The indicator works well only in a trending market. In a ranging or sideways market, the PSAR often produces many inaccurate reversal signals, leading to false trades.

Detailed Summary

The Parabolic Stop and Reverse (SAR) indicator, developed by J. Wells Wilder, is a trend-following tool used primarily to identify trend direction and function as a trailing stop technique. It relies on the previous SAR value, the Extreme Price (EP), and a dynamic Acceleration Factor (AF) for its calculation. The AF starts typically at 0.02 and increases by 0.02 up to a maximum (usually 0.20) whenever a new EP is reached. The indicator is plotted as a dotted line, signaling a bullish trend when the price is above the SAR and a bearish trend when the price is below. The mechanism generates a stop and reverse signal whenever the price touches the SAR, making it a disciplined system for entries and exits, though it performs poorly in non-trending (ranging) markets.

Key Takeaways

  • The Parabolic SAR (PSAR) is a trend-following indicator developed by J. Wells Wilder.
  • Its two main uses are identifying trend direction and serving as a trailing stop loss mechanism.
  • The current SAR is calculated using the previous SAR, the Extreme Price (EP), and the Acceleration Factor (AF).
  • The AF is dynamic, typically starting at 0.02 and increasing by 0.02 up to a cap (usually 0.20) upon reaching a new EP.
  • A bullish trend is signaled when the price is above the SAR dots; a bearish trend is signaled when the price is below.
  • The indicator accelerates toward the price; when the price touches the SAR, a stop and reverse signal is generated, moving the trader from a long to a short position (or vice versa).
  • PSAR is considered a complete and disciplined trading system that provides clear entry and exit points.
  • The major limitation is its poor performance in ranging or sideways markets, where it generates frequent false reversal signals.