What is Parabolic SAR Indicator

Parabolic SAR Indicator: Meaning, Calculation, Pros & Cons

You can make online share trading easier if you have a tool that tells you where the stock price is going and where the best entry and exit points are. Well, in the 1970s, Welles Wilder developed the Parabolic SAR Indicator, a powerful tool for technical analysis. It helps traders determine the direction of stock prices. 

This indicator shows traders whether an asset is in an uptrend or downtrend by displaying dots on a chart. In an uptrend, the dots appear below the price line, while in a downtrend, they appear above. In this article, we will explore the Parabolic SAR indicator, its calculation, how it works, how to trade with the Parabolic SAR indicator, and its pros and cons.

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What is a Parabolic SAR Indicator?

In the 1970s, Welles Wilder developed the parabolic SAR Indicator. A parabolic stop and reverse is a technical analysis tool. Additionally, it is based on the belief that history repeats in the stock market, enabling one to make gains by predicting a stock's trajectory.

It's a trend-following indicator that helps traders figure out where the price is going. On technical charts, PSAR shows up as a series of dots above or below candlestick bars. Basically, if the dots appear below the price line, it means the uptrend will continue. If they're above the price line, then it means the sellers are in charge and the downward trend will continue.

Using the Parabolic SAR, you can set a trailing stop loss or find entry and exit points based on asset prices staying in a parabolic curve during market trends. Here's a simple example:

Imagine a trader is looking at the price of a stock and notices that the Parabolic SAR dots are below it, indicating a downtrend. Traders can use this information to set a stop-loss order above the dots to limit losses.  

When the stock price drops, the Parabolic SAR dots move lower, signalling a strong downtrend. In that case, the trader might decide to hold onto the stock until it's dots move above the stock price, indicating a possible trend reversal, and then consider selling it to take profits. 

Parabolic SAR Indicator: Calculation

To figure out where the series of dots will be located, the Parabolic SAR indicator uses the latest extreme price (EP) plus an acceleration factor (AF). In an uptrend, EP is the highest high the asset has reached, while in a downtrend, EP is the lowest low it has touched. Moreover, the EP is updated every time a new EP is reached. As a default, the AF is set to 0.02 and increases by 0.02 for each EP. 

For uptrend security, PSAR is calculated as follows:  

Uptrend security PSAR = Prior PSAR + Prior AF (Prior EP – Prior PSAR)

Here's how PSAR is calculated for a down-trending stock:

PSAR for downtrend security = Prior PSAR - Prior AF (Prior PSAR - Prior EP)

The series of dots shows the current price momentum. By using this formula, you can tell if a dot is below or above a rising trendline. Also, if you want, you can connect the dots with a line. 

How to trade Parabolic SAR Indicator

When using the PSAR, traders usually buy a security if the dots shift below the candlestick bars, implying upward momentum. whereas, they sell or short-sell if the dots shift above the candlesticks, indicating downward momentum.

So, if a trader keeps using this strategy, they will get trade signals all the time because they always have money invested in the asset. This can be helpful if the asset keeps changing in value, as the trader can make money on each trade. However, if the asset is only moving a small amount in both directions, the constant trade signals could result in a bunch of trades that end up losing money. 

Therefore, it's best to analyse the price chart of the trading session to determine whether there's a strong upward or downward trend. A moving average is another technical indicator that can be used to determine the overall trend direction. 

Pros and Cons of Parabolic SAR Indicator

Parabolic SARs are helpful for determining price movement directions. When there's a strong trend, the indicator works well. Also, whenever there's a move against the trend, the indicator gives an exit signal when a reversal could happen. When markets are trending with long rallies or declines, this tool works the best. 

On the downside, when price action starts moving sideways, the Parabolic SAR gives false signals. In the absence of a trend, the indicator bounces back and forth around the price bar, giving misleading signals. Thus, if you only use the Parabolic SAR during sideways market conditions, you can lose money. 

Conclusion

The Parabolic SAR Indicator offers traders a powerful solution for technical analysis. By visually representing the trend direction through dots on a chart, this indicator provides valuable insights. When the dots appear below the price line, it signifies an uptrend, while the dots above indicate a downtrend. With the Parabolic SAR, you can set trailing stop losses and make informed decisions based on asset prices following a parabolic curve.

However, this tool has its own pros and cons. The indicator performs exceptionally well during strong trends, providing valuable signals and exit points when trends reverse. Even so, you should be cautious during sideways markets, since the Parabolic SAR might produce misleading signals. Furthermore, to maximize the benefits of the Parabolic SAR, it is recommended to combine its usage with other technical indicators and conduct a thorough analysis of the price chart.