Technical Classroom: How to use parabolic SAR indicator for trading

Parabolic SAR was originally named "Parabolic Time/Price System" with SAR an acronym for "stop and reverse". Technical analysts often refer to the indicator as simply "SAR" or "PSAR".

It finds the potential reversals in the price of traded assets such as securities and currency & commodities and can be used to provide the entry and exit points.

One of the most interesting aspects of this indicator is that it assumes that the trader is fully invested in a position at all point in time. For this reason, it is of specific interest to those who develop trading systems and traders who wish to always have money at work in the market.

Construction of Parabolic SAR Indicator

The PSAR indicator is somewhat complex to calculate by hand and most traders simply use trading software to chart it. Parabolic SAR (SAR) is a time and price technical analysis tool primarily used to identify points of potential stops and reverses.

When graphically plotted on a chart, the Parabolic SAR indicator is displayed as a series of dots. When it appears above the price bar, the parabolic SAR is interpreted as a bullish signal, whereas when it is positioned below the price bar is deemed to be a bearish signal. The signals are used to set stop losses and profit targets.

Working of Parabolic SAR Indicator

> A small dot is placed below the price when the trend of the asset is upward, while a dot is placed above the price when the trend is downward. As can be seen from the chart below, transaction signals are generated when the position of the dots reverses direction and is placed on the opposite side of the price.
> When the price of a stock rises, the dots also rise. The rise is slow at first, and the pace then accelerates with the trend, before catching up with the asset price. The Parabolic SAR works well for capturing profit targets by entering the trade during a trend in a steady market.
> The change in the direction of the dots produces trade signals, which can produce a profit when the price makes big swings. However, if the price moves sideways, it can produce continuous losses or small profits, especially in an unsteady market.
> The parabolic SAR performs best in markets with a steady trend. In ranging markets, the parabolic SAR tends to whipsaw back and forth, generating false trading signals.
> Parabolic SAR creates a parabola on the chart. The parabola is always below the price in an uptrend and above the price in a downtrend.
> Traders may also use candlestick patterns or moving averages for better results.
> The indicator can also be used to set stop loss orders. It can be achieved by moving the stop loss to match the level of the SAR indicator.
> Extreme Point: The extreme point is the highest high of an uptrend and the lowest low of a downtrend. The difference between the previous extreme point and the previous PSAR is the value that is multiplied by the acceleration factor to determine the change in PSAR with each round of calculation. Thus, a larger deviation in the extreme point from the Parabolic SAR will result in a larger movement of the current PSAR towards the current stock price.

> Maximum Step: The maximum step is the maximum value that the acceleration value is allowed to reach. That is, once the acceleration reaches the maximum step – typically set to 0.20 – it will remain at that value until the trend reverses and the acceleration factor resets to its initial value. A lower maximum step makes the PSAR less likely to signal a reversal, since it limits the acceleration on the PSAR, while a higher maximum step can make the PSAR more likely to signal a reversal.

Trading Technique:

Trading with ADX

The Parabolic SAR mainly works in trending markets, and Wilder recommends that traders should first establish the direction of the trend using a parabolic SAR and then using alternative indicators to measure the strength of the trend. We have used ADX, +DI & - DI indicator for considering the strength of the trend with parabolic SAR.

Buying with SAR
1. ADX trading above (20).
2. +DI is greater than – DI
3. Parabolic SAR point is below candle (bullish signal

Selling with SAR
1. ADX trading above (20).
2. -DI is greater than + DI
3. Parabolic SAR point is above candle (bearish signal)

Rather than putting in one stop loss below where a trader entered a long position or above where the trader entered a short position, using the Parabolic SAR as a trader's guide, the stop loss is gradually raised for a long position and lowered in a short position, effectively locking of profits. It acts as a time stop too. Traders should use the SAR in conjunction with other technical indicators to maximize their odds of success.

Conclusion
> The benefit of using a Parabolic SAR is that it is used to determine the direction of the price.
> The PSAR – parabolic stop-and-reverse – indicator is plotted on a price chart and is intended to signal when an uptrend or downtrend in a security’s price is about to reverse.
> The indicator tends to produce good results in a trending environment, but should not be used when the price starts moving sideways.

(The author is Head-Technical & Derivative Research at Narnolia Financial Advisors)

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