The stock market is very volatile and we cannot predict future price movements. But we can make conclusions by taking into consideration charts, patterns with the help of varied indicators. Technical indicators are very crucial if you’re trading into stocks. It helps the traders to determine the trend and suggest a valid direction. Some of the very popular technical indicators you might have heard of are moving averages, RSI (relative strength index), MACD (moving average convergence divergence), Bollinger bands, etc. But today, we will be learning about an uncommon indicator mostly used by advanced traders. And it is named Parabolic Sar.
In this article, you will be reading about Parabolic Sar and know how it helps in spotting trends and reversals.
The parabolic sar is also known as the parabolic stop and reverse is a simple to use trend indicator. It was developed by J. Welled Wilder, who is popular for his work in technical analysis. It does a very good job of providing us with both entry and exit signals. The indicator would look like a boundary with multiple dots that are positioned to be either above or below the candle.
The way we analyze the market using this indicator is actually very simple. If the dots are positioned below the candle, it indicates that the current market is on an uptrend and if the dots are positioned above the candle, it indicates that the current market is on a downtrend. The distance between the dot and the candle also reflects how strong the trend is. Let us show you an example with reference to this picture.
Here we can see that the dot is below the candle indicating that the current market is on an uptrend. Then as the uptrend starts gaining momentum notice that the distance between the dot and the candle also increases. After that as the momentum starts getting weaker the distance between the dot and the candle also becomes narrower.
Until finally the dot switches to above the candle indicating that the direction of the trend has now reversed to the downside. The different strategies that you can use with the parabolic sar. So, first, a common strategy that is often used by beginner traders is they simply take long or short entries based on the position of the dots alone. For example, when the dot switches to below the candle they take long positions and when the dot switches to above the candle they take short positions.
How Parabolic sar is calculated
Every indicator is derived from some calculations. On the basis of those calculations’ signals are generated. There are different calculations of parabolic sar for an uptrend and downtrend.
Uptrend Parabolic sar= Prior PSAR + Prior AF x Prior EP- Prior PSAR
Downtrend Parabolic sar= Prior PSAR – Prior AF x Prior PSAR- Prior EP
Where, PSAR is symbolic for parabolic sar, AF is acceleration factor, EP is extreme price. All these calculations are performed to form the dots around the price chart of the stocks.
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Problems to Parabolic sar strategy
Now, despite this being a famous strategy there are actually a couple of problems.
- The parabolic sar is a trend indicator meaning it only works on trending markets. Remember markets aren’t always trending, it can also move within range.
And because the parabolic constantly shows signals non-stop it means that it’ll also show signals even when the market isn’t trending.
Let me show you an example here we can see that the parabolic. They are switches to below the candle indicating that the market is on an uptrend and according to the strategy we take a long position. Here next we can see that the trend has ended and the market started moving sideways. However, notice that the parabolic star is still displaying entry signals even when the trend has already ended. As a result, all the signals that the indicator displays on this ranging market ends up being a loss. So, in short, the parabolic star only works on trending markets. If the market is on a range like as show in the above picture, it will display many false signals.
- The second problem with using the Parabolic sar is that it doesn’t take the long-term trend into consideration. Let me explain so let’s say you enter a short position here because the parabolic are switches to above the candle.
Now, if you zoom out and look at the overall chart you can see that the overall market is actually on an uptrend. So, if you took a short position here based on signals from the parabolic area alone. It means you are actually trading against the overall trend which is not a good idea. That is why the solution to this is you need to combine the parabolic star with another indicator that can detect the long-term trend. An example of that would be the 200-period exponential moving average.
So, here’s how the full strategy would work. The first step is you want to identify the long-term trend and you can do that by looking at the position of the price relative to the 200 ema. If the price is above the 200 ema it indicates that the long-term trend is up. If the price is below the 200 ema it indicates that the long-term trend is down. Now, once you’ve identified the long-term trend the next step is you want to wait for the parabolic star to show the same signal as the long-term trend.