Most commonly known as the “stop and reversal” indicator the Parabolic SAR is one of the most straightforward indicators for traders to interpret. Welles Wilder, also of average directional indicator and relative strength indicator fame, developed this indicator with the purpose of attempting to pinpoint the highest probability of price reversing. He suggested that, used in conjunction with a trend-finding indicator such as the ADX, the Parabolic SAR could be extremely useful in providing an indication of when a market can be traded successfully. Wilder also pointed out that, whilst the Parabolic SAR works extremely well in trending markets, its downfall is when it is applied to a flat market and results in whipsaws and false signals. The principal rule in applying the Parabolic SAR to trading is thus to first establish that the market is trending.
On a chart the Parabolic SAR appears as a series of small dots both below and above the price. These dots give traders an indication on the trading direction of the price. When the dots are situated below the price then this is considered a bullish (upward) sign and often price will trend up when the dots are below. The reverse signal is given when the dots are positioned above price, this is seen as a bearish (downward) trend. The dots are strategically situated in relation to the price and, during a strong upward trend, they will be seen to be detached from the price without touching it. As momentum of a trade increases and price rises higher, so do the dots below the price, increasing in gradient and moving close to the underneath of the price bars. Traders watch to see how the Parabolic SAR interacts with the current price in order to confirm a trading signal.
Trading signals are generated when price moves below one of the underlying dots. This is often after a trending move and observers see this as an indication that the market may be about to ‘stop and reverse’. Whilst the dots are stationed either below or above the price it can be considered that the market is trending and when price interats with a dot by touching or moving below/above it is a signal of the reversal. The Parabolic SAR is incredibly accurate and mechanical in this respect, it allows traders to see an entry with a high level of objectivity and, in trending markets, is an invaluable tool to pre-empt reversal swings in price.
One problem, however, which is difficult to mitigate is that the use of Parabolic SAR is only really effective when markets are trending. Without a trend the dots will interact often with price and in choppy markets this leads to a lot of signals being generated. Like every indicator, the Parabolic SAR is best used with another reinforcing signal, such as a momentum oscillator to reaffirm when a stock, currency or commodity is considered over-sold or over-bought. The confirmation that price is due a reversal using a supplementary indicator will increase the probability that the market will reverse substantially and not simply move sideways causing a frustrating level of false signals. Likewise, the use of candlestick reversal patterns to confirm that the market is about to move in the opposite direction is also a very profitable addition to the Parabolic SAR.
One of the most popular uses of the Parabolic SAR by institutional traders is a by-product of its ability to indicate when a stock, currency or commodity may be coming to the end of its short-term trend. This is the use of this indicator as an excellent guide of where a trailing stop-loss should be placed. If, for example, a trader is currently trading a bullish trend and wants to be able to lock in profits as price rises but without risking further upside potential, placing a stop-loss at the value of the dots below the price is highly effective. The trader knows that, should price interact with these dots then it is highly likely to reverse and therefore his position can be closed. Importantly, this allows the stop loss to be mechanical and devoid of emotion. The trader knows that once the dots have been breached the probability of losing profit is much higher than gaining more.