Parabolic SAR Explained

Are you struggling to trade with the same emotional control as displayed by Doctor Spock? Well here’s an easy to use indicator that sorts out the entry and exit points for you.

Explanation
The Parabolic SAR is another winner from the famous J. Welles Wilder stable. Yes, if that name sounds vaguely familiar it’s because he came up with the Relative Strength Indicator and the Directional Movement Indicator. Either that or you’re thinking of the curly-haired wally who lusted after Kelly Le Brock in Woman In Red.

This is a time/price reversal system designed for active traders ( the SAR stands for Stop and Reverse). It works as an easy-on-the-eye set of coloured dots. When the price is above the (green) dots you buy the market; when the price is below the (red) dots you sell the market. The cunning plan is that when the dots change colour, you reverse your trade position.

Under The Bonnet
As the beauty of this system is its simplicity I’m not going to spoil it all with any long formulas.

Wilder designed this as a trend-following system. As the price movement begins, the pattern of dots is fairly flat and some distance from the price. But as the trend takes off, an accelerator factor kicks in, causing the dots to catch up with the price.

The system takes its name from the parabola shape the curve takes on as the trailing stops track the price.

The calculation is pretty complex, taking into account both timing and prices to work out acceleration factors, but we don’t need to go any further than that on an introductory session.

Where To Find The Parabolic SAR
On your chart, click on the ‘settings’ box in the bottom left-hand corner. This will bring up the menu where you’ll find it, marked as Parab SAR, just below Bollinger bands.

The data option boxes relate to the level of acceleration in the curve, but unless you’re a real pointy head I’d suggest using the default settings.

How Do We Use It?

Active Trading
Active traders use this as a simple change-of-direction indicator; buy when the dots are green, sell when they’re red (see the first chart at the top of the page).

But beware; this works best in a trending market; if there’s no trend you’ll get caught up in a series of nasty whipsaws that’ll run down your trading balance.

It’s a good idea to use some form of trend indicator (the 21-day moving average, a 3-MAV combo, or the ADX/DMI) first to test the waters for a trend. Personally, I’d only take the trades going with the underlying trend.

Stop Loss Management
This provides a simple solution to the dilemma not so much of where to place the initial stop loss, but how and where to trail the stop once the trade gets moving. In a rising market use the green dot as the stop loss, in a falling market, yep, you’ve guessed it. Zebu showed good examples of this in his article on setting-stop-loss-orders.

The nature of the accelerator process means that the Parabolic line gives plenty of breathing room at the start, but as the trend gets going the stop tightens up, allowing the trade to capture most of the gains.

Conclusion
So, there you have it; the Parabolic SAR isn’t the traders’ Holy Grail; none of them are. But it’s another useful indicator to follow; it can take the decision-making out of trades, if that’s what you want, and it’s a useful guide for setting your stop loss target. Now you’ve been introduced, this indicator will feature from time to time in the daily TA piece.

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