The Parabolic SAR is a technical indicator based on both price and time used to signal reversals in trends, with the SAR referring to “stop and reverse”. The idea is that the Parabolic SAR is used as a trailing stop loss and to reverse a position on a close below this level. Developed by Welles Wilder and published in his 1978 book New Concepts in Technical Trading Systems the calculation is very complex and beyond the scope of this article.
To interpret the Parabolic SAR we examine whether the indicator is above or below the current price. When the SAR is below the price the trend is up with the SAR acting as a stop loss, alternatively when the SAR is above the current price the downtrend is down with the SAR again acting as a stop loss.
As the price continues in the direction of the trend the SAR continuously follows and never decreases if the trend is up or increases when the trend is down and this is to prevent the manual adjusting of the stop loss and to protect profits.
The steps that the Parabolic SAR moves in is based from an acceleration factor that can be adjusted to change the sensitivity to movements in the price. By decreasing the acceleration factor the sensitivity of the SAR will decrease, providing more leeway as a trailing stop while increasing the acceleration factor will make tighter the stop loss. By increasing the acceleration factor we increase the risk of the stop loss being triggered and reversal signals generated however the trade-off is that it tends to protect capital and profits more aggressively. There is a clear trade off that depends on the preference of the individual trader.
The chart below shows the Parabolic SAR with an acceleration factor of 0.02 for TLS. We can see in late June the price trends higher to reach a high at $5.86 on the 21st of July. During this time we can see the Parabolic SAR represented by the red dots trails the price higher. On the 26th of July we can see that the price closes below this trailing stop and the indicator then reverses, evidenced by the red dots now appearing above the price. This confirms a change in the trend to down and acts as a stop loss for a short position.
The second chart below shows TLS once again however this time the acceleration factor has been increased to 0.10 which acts as a reminder increasing the sensitivity of the indicator to movements in price and tightens the stop loss. As a result we can see there is an increased number of false signals where the stop loss is triggered and the position reversed, only for it to happen again almost immediately. In the case following the July 21st high at $5.86 the price moves lower before the stop loss is triggered and the trend changed to up on August 1st. Then two days later the stop loss is triggered once again and the trend changed to down on August 3rd. This example goes to show the effect of making the indicator move sensitive, in that is protects capital and profits more aggressively however generates larger numbers of false signals.
This indicator is very useful for trending securities however as markets tend to trend less than 50% of the time this indicator is subject to false signals when a security is not trending strongly. There is no ideal setting and depends of the preference of the individual trader, but when used correctly it can be a very valuable indicator and trading system. As always this indicator should be used with further analysis to confirm signals.
If you are interested in identifying trends using technical indicators you may find part three of our technical webinar series useful, simply click here.
