Parabolic SAR is one of the best known trend-following indicators. Designed by J. Welles Wilder, it is a parabolic inversion system that is based on the price / time variable and allows the analyst to be given a continuous operation until a Stop is reached, a signal that expresses the inversion of the position.
Hence the meaning of the acronym SAR, Stop and Reverse: the indicator reverses when prices pierce it up or down, thus indicating the closure of the existing position and the opening of a possible new position.
The Parabolic SAR, is calculated in this way:
SAR(x+1) = SAR(x)+ α(EP-SAR(x))
The Parabolic SAR is a TRENDFOLLOW indicator that overlays the price chart. It appears as a parabolic curve that can be above prices if the trend is bearish or below prices if the trend is bullish.
The Parabolic SAR curves are composed of signals located at variable distances between them. The signals are called Stop and at the time of the start of a new trend they start slowly and with little inclination. The inclination depends on an acceleration factor of the system, specially designed by Wilder so that every day the stops can move in the direction of the new trend, allowing the indicator itself to settle in the initial stages of directionality.
The more the distance between the SAR signals and the price is greater, the healthier the trend is and is maintained. The approach of the signals to the price line establishes a deterioration of the trend with probable change of the same.
The directional change establishes the Reverse, indicating the trend change only at the next candle of the selected time-frame.
As already mentioned, the Parabolic SAR, together with the moving averages, is an excellent trend-following indicator.
The curved lines of signals that develop on the chart assume the role of dynamic resistances and supports. In this case, if we are in an uptrend and the Parabolic SAR develops below the price chart, it will take on a supporting role; on the contrary, if we are in a downtrend and the indicator is above prices, it will be a resistance to overcome.
Each signal composing the curves materializes according to the reference time frame. As with most indicators, the Parabolic SAR can also be set to all time frames depending on the operator’s study needs.
Specifically, each signal is created on the chart at each candle closure of the chosen time frame, for example if the chart is set on time frame 4H, a signal is generated every 4 hours.
An important feature is the role that Parabolic SAR can play in identifying Stop Loss levels. The Stop Loss is a price level chosen by the trader in which open market positions are closed automatically: it is the way to safely manage the portfolio and limit any losses. Let’s take a more concrete example: we are in the mountains and we are about to climb Everest without a safety rope. The Stop Loss, for those who operate on the financial markets, is that safety rope that prevents us from falling ruinously.
The signals generated by the parabolic SAR can therefore be interpreted as an indication of the Stop Loss levels and therefore as a signal for closing positions.
More specifically, if we are in a defined uptrend and we are in the market with a long position, the moment in which prices violate the dynamic support created by the indicator is the closing signal of the position. Conversely, if we are in a defined downtrend and we are in the market with a short position, the moment in which prices violate the dynamic resistance created by the indicator is the signal to close the position.
The Parabolic SAR, being a Stop and Reverse indicator as well as providing signals indicating a possible exit from the market, with the same mechanism indicates the favorable moments for possible market entry. If we are in a downtrend, a possible signal to open a buy position will be given by the prices that pierce the indicator line from the bottom to the top, on the contrary, if we are in an uptrend, a possible signal to open a short position, will be given by the prices crossing the indicator line from top to bottom.
It should be remembered that just as the indicator is excellent for trend phases, it is equally ineffective in the lateral phases of the market, in which, if not properly filtered and / or combined with other indicators / oscillators, it can provide false signals.
According to Wilder’s own estimates, most of the indicators that follow the trend work well only in periods in which it proves very strong, that is 30% of the time1.
1 Technical analysis of financial markets, methodologies, applications and operational strategies, HOEPLI