Parabolic SAR or Parabolic Stop and Reverse indicator was developed by J. Welles Wilder. It is one of the commonly used technical analysis indicators to signal when the trend may be reversing and hence when to stop and reverse the trade position.
This indicator works well when there is a strong uptrend (bullish market) or strong down-trend (bearish market). It does not work well when the market is running sideways i.e. in ranges.
Please note that here our explanation may be focused for technical analysis for Forex trading but the same explanation is equally valid for stocks or any commodity trading using this indicator.
When you select this indicator on your trading platform chart, you will see dots above and below the chart. Please see the chart below:
In the forex chart above you will see green dots appearing when prices is moving up and red dots when there is a downward movement. Please note that the default colors for Parabolic SAR indicator on your trading platform’s chart may be different and can be set as per your choice.
The first green dot below the chart appears as an indication of upward movement and then with every upward move subsequent green dots will appear. Similarly the red dot over the chart appears to indicate downward movement and then with every downward move subsequent red dots will appear. The dots in the same direction keep on appearing till a reversal of the trend is confirmed and not before Parabolic SAR confirms the reversal of the trend.
When the market is moving up and you have a long position, follow Parabolic SAR green dots (dots below the chart). When the green dots hit the chart, SAR signals to exit your trade or for entering a trade in reverse position (short-sell), expecting that market may start going down.
When the price is going down and you have a short position (short-sold the pair), follow the red dots (dots above the chart). When the red dots hit the chart, it is a signal to exit the trade or for entering a trade in reverse position (buy the pair), expecting that market may start going up.
Parabolic SAR can also be used for putting trailing stops for your trade i.e. You may consider placing your stop at the levels of appearing dots below the chart when market is moving up and at the dots above the chart when there is a downward move. “Trailing stops” means moving your stop-loss level upwards when the market is moving up and moving your stop-loss level downwards when the market is going down. Using trailing stops in is good as it continuously reduces the risk in trading. This will be explained below.
Parabolic SAR can indicate when there is a possibility of a reversal of the trend and hence we can use the signals for stopping and reversing the positions. This indicator can also be used to find the levels to put trailing stops.
In the chart 2 above, Points A, C, F, H and I are the points where the falling red dots intersected the candlestick chart. The price before these points was going down and had just started going up.
Points B, D, E and G are the points where the rising Parabolic SAR (blue dots) has intersected the chart. The price before these points was going up and had just started going down.
Point A indicates the stop and reversal when, earlier, we might have entered the market for a short position (short-sold), when the market was been bearish. We will not talk about point "A" because the down-trend before point A is not visible in this chart.
Point B: There was a uptrend starting at point X. The market was going up. Suppose we had entered the market for a long position near point X. There was an upward move and we are in for a profitable trade. The movement continued till point P and suddenly it started dropping. We would stay in the trade because the fall might be a short term correction i.e. when the market falls slightly and start moving again. But at point B, the rising Parabolic SAR dots hit the chart. Well, this signaled an exit as it indicates that a reversal in the direction might have taken place. What would have happened if we would not have closed our position at point “B”? The downward move continued up to the small horizontal red line below point “C”. We would have ended up at much less profit if you would not have closed your position at point B.
There can be an argument that the prices have gone up again after falling to the horizontal small red line. But then its always better to play safer in trading as cutting the losses is equally important as making profits.
Suppose at point “B” we come out from the long position and reverse take another short position i.e. we short sell to make a profit if it falls further. Well, at point “C” the falling SAR line (red dots) intersected the chart. This point “C” signaled a “Stop and reversal” again. In such situation we come out of our short position by taking a profit and may enter a long (buy) position. If we did that, then we entered another trade as the market started moving up after that point. We then come out of this long position at point D. Point “D” did not prove to be a good signal but then playing safe may always be better. After point “D” the price moved up again and next signal to come out was at point E. If we did not come out at either point “D” or “E” then we would have ended up at a loss instead of profit as the there was a fall down to the point R.
You may check all other points in the candlestick chart in chart 3 to see how those Parabolic SAR trading signals worked.
Having trailing stops is one of the very important strategies for profitable trading.
During uptrend: Moving stop-loss level upwards from previous levels when the market moves up and we are in long position.
During downtrend: Moving stop-loss level downwards from previous levels when there is downward and we are in short position.
In simple words suppose we buy USD/JPY when 1 USD = 100 JPY. We are certain that the price is going to go up. In case the market goes down, instead of going up, we put a stop-loss order at 1 USD = 99.50 JPY.
As per the expectation and analysis, the currency pair (in this case USD/JPY) price start going up. It reaches 1 USD = 100.50 JPY. We are still expecting that the market will still go up further. At this point suppose we move the stop loss order from the previous 1 USD = 99.50 JPY level to 1 USD = 100.10 JPY. Now in case the analysis goes wrong and there is a heavy fall, we still come out with some profit instead of loss.
Parabolic SAR may help in knowing the levels for moving the stops up and down.
We could move the stop positions from one dot to the next dots. In the above forex chart #3, suppose we enter the long position at Point A with a Stop Order at X. The market moves up and we move our stop from X to Y, following SAR green dots (rising SAR), we cut down our chances of losses.
We explained Parabolic SAR in the for technical analysis in context of Forex Trading but the same stands good for stock trading or any commodity trading.
More on Parabolic SAR.