Parabolic SAR

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Introduction

Welles Wilder in his seminal book, “New Concepts in Technical Trading Systems”, Wilder introduced the Parabolic SAR system.  SAR which means Stop and Reverse was designed to eliminate some of the frustrations created by lag effect inherent in trading strategies that employed moving averages.

One of the primary ideas behind the Parabolic SAR is that time is an enemy and once a position is initiated it must continue to be profitable or it will be closed.

Formula

SAR (tomorrow) = SAR (prior) + AF + [High (today) – SAR (prior)

Where:

AF= acceleration factor typically set at .02

To calculate SAR, you first need to assume a long or short position and start calculating from where the market has moved above the most recent low (for long positions) or below the most recent low (for short positions). For example in a long position, the lowest low is the starting point for the calculations to begin It is important to understand that each Parabolic SAR point is essential calculated independently for each trend in the price. The next SAR value is calculated using data from the prior date.

The SAR is basically an exponential smoothing technique using the prior high or low.  The smoothing constant is the AF which starts at .02 once a position is initiated. After each new high or new low the AF is increased by .02. This will decrease the lag between price and the SAR.

To prevent trades from being closed early, Wilder incorporated a rule by not allowing the SAR to enter the price range of the most recent 2 days.

When the price is in an uptrend, the SAR appears below the price and converges upwards towards it. Similarly, on a downtrend, the SAR appears above the price and converges downwards.

SAR sensitivity can be increased by increasing the Acceleration Factor (AF). By increasing the Acceleration Factor SAR is moved closer to prices, increasing the odds of a reversal signal. If the Acceleration indicator is too high the Parabolic SAR will produce too many whipsaws and decrease the odds of catching a trend break out.

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Indicator Interpretation

What separates the Parabolic Stop and Reverse (SAR) from other indicators is its unique combination of price and time components to generate buy and sell signals. Once a trend is identified, SAR trails price as the trend extends over time. In rising trends the indicator is below prices and declining trends SAR is above prices. This characteristic makes The Parabolic SAR an effective as a tool to determine where to place stops. Once prices break above or below the indicator, positions are stopped and reversed. In the SAR system, traders are always in the market.

Buy Signal

The Nice thing about the Parabolic SAR is that it is very easy to follow and the signals it generates are very easy to see. A buy signal occurs when the price closes above a prior upper Parabolic SAR trend. When the Parabolic SAR changes from being above price to below price, then assuming you have a short position you then liquidate your short position and go long. The Parabolic SAR system always assumes that you have a position in the market at all times.

Sell Signal

A sell signal is occurs when price closes below a prior lower Parabolic SAR. When the Parabolic SAR changes from being below price to being above price, the trader should close the existing position and reverse direction by going short.

Like most Technical indicators traders can improve their analysis by combing the SAR with other indicators. By using additional indicator or methods, trader can have for confirmation on trading signals. Welles Wilder recommended using the ADX indicator with the Parabolic SAR. He suggested using the ADX to first identify the direction of the trend and its strength. Once that was done, the Parabolic SAR should be used to trade the identified trend.

Conclusion

The Parabolic SAR is a good tool for trend followers and longer term traders searching for longer term trends. SAR can be used to keep traders focused on the direction trend and it can help them manage their risk. By adding the use of additional indicators like the ADX, traders are able to determine when the markets are trending and the use the Parabolic SAR for trade management.