Active traders have a vast array of technical tools and indicators to deploy. One of the most basic and useful is the parabolic SAR (PSAR).
In this blog article, we’ll answer the question “What is the parabolic SAR?” and break down its applications in the live market.
What Is the Parabolic SAR?
Developed by technician J. Welles Wilder, Jr., the parabolic stop-and-reverse (SAR) is an indicator used to identify market reversals. It’s represented as a graphic overlay, a series of dots placed above or below price action. Each dot is calculated by accounting for several factors:
- Trend extremes: These values are either the most recent highest high or lowest low of the periodic trend.
- Acceleration: The acceleration factor is the rate at which new trend extremes are being established. This value may vary, but Wilder’s original work alludes to a default acceleration factor of 0.02.
So, exactly what is the parabolic SAR? It’s an indicator used to locate market entry and exit points with respect to a potential shift in market direction. This functionality is accomplished differently depending on whether the prevailing trend is bullish or bearish.
Bullish Trend
Amid an uptrend or bullish market move, the parabolic SAR exists as a series of dots beneath periodic price bars or candlesticks. As dots are plotted, they represent rising prices and suggest that a bullish bias is warranted.
Using this information, traders may choose to open a new long position in the market. As long as the PSAR is located below price action, the prevailing trend is up. However, when the PSAR rotates above price, exiting long positions or entering new shorts become viable alternatives.
Bearish Trend
During a downward or bearish trend, the parabolic SAR exists as a series of dots above price action. As long as dots continue to be plotted above price action, prices are trending to fall and a bearish market bias is warranted.
Any trades are educational examples only. They do not include commissions and fees.
Given this scenario, parabolic SAR traders may choose to sell the market or allow existing short positions run. When the PSAR jumps back above price, that’s a signal to close existing shorts and possibly open fresh long positions.
PSAR Example
Are you still unclear about the parabolic SAR? Perhaps a real-world example will help.
Assume that Erin is trading the E-mini S&P 500 on a 30-minute time frame. Erin notices that the PSAR is beneath price action and has been for 10 price bars. This information suggests three possible courses of action:
- If already long the E-mini S&P 500, Erin may hold the position.
- Erin may buy an E-mini S&P 500 contract(s).
- Erin may wait for the PSAR to jump price and short the E-mini S&P 500.
If the PSAR was above price, Erin would have opposite alternatives: She could hold active shorts, sell the market, or wait for a bullish reversal.
PSAR Shortcomings
Like all other technical indicators, the parabolic SAR isn’t infallible. Although it’s a powerful trend-following and reversal trading indicator, there are a few disadvantages to be aware of:
- The PSAR can produce false reversal signals during strong trends.
- In sideways or choppy markets, the PSAR can create an abundance of false signals.
- On condensed time frames, the indicator has a reduced efficacy.
As with any strategy, it’s important to trade the PSAR with prudent risk management parameters.
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