In trading, profits or losses are defined by a trader's ability to anticipate price action. Several indicators can be used to assist in predicting future price action, but few are as easy to interpret or are as useful as the parabolic SAR.
The parabolic SAR (Stop and Reverse) is an indicator often used by traders to determine the direction of future price action, and the point on the chart when this momentum shift has a higher-than-average probability of taking place. The parabolic SAR uses price and time components to create buy and sell signals. The indicator can also be utilized as a way to establish where stop loss orders can be placed. The indicator is visible on charts using plots, crosses, or lines and can be customized, but I recommend going with the default settings..
Parabolic SAR is shown on the AAPL chart below with a line format:
The parabolic SAR follows price, and as such should be considered a trend indicator. Once a reversal takes place within a downtrend and turns upward, the parabolic SAR will follow the price action. The parabolic SAR continuously increases as long as the uptrend remains valid. As a result, the parabolic SAR never falls within an uptrend, so when the price crosses the SAR to the downside, the short term uptrend has essentially reversed.
Once price stops rising and reverses below the SAR, a downtrend starts and SAR moves above the price. The SAR will then follow price action lower. The SAR will continuously fall as long as the downtrend continues. As a result, the parabolic SAR never rises within a downtrend, so when the price crosses the SAR to the upside, the short term downtrend has essentially reversed.
Simply put, you want to be long when the SAR is below the price, and short when the SAR is above the price.
Parabolic SAR Buy and Sell Signals
The buy signal occurs when the price breaks and closes above the parabolic SAR. When the parabolic SAR crosses over from being above the price to below the price, it gives traders the opportunity to "stop" buy to cover their short, "reverse" direction, and go long on the trade.
The sell signal occurs when the price breaks and closes below the parabolic SAR. When the parabolic SAR crosses over from being below the price to being above the price, this gives traders the opportunity to "stop," sell to close their long, "reverse" direction, and short the stock. Examples can be shown below on a 5 minute chart for AAPL using plots:
Stop Loss Placement
For all of you hard stop loss fans out there, you can utilize this tool to determine where to place your stop loss to protect your gains or minimize your losses. When used this way, the indicator can act as a trailing stop.
So instead of putting one stop loss below your entry on a long position or above your entry entered a short position, the parabolic SAR can be used as a guide for increasing or decreasing your stop throughout the trade. The stop loss can gradually be raised for a long or lowered for a short, essentially locking in any profits along the way.
Because so many traders utilize this tactic, and so many stops are executed during a crossover, the parabolic SAR is respected throughout the market. For this reason, a parabolic cross generally results in a nice pull or push depending on the direction of the crossover.
Conclusion
Overall, the parabolic SAR is a great tool and indicator for all types of traders. From the beginners that are still trying to figure out where the best entries and exits are on each time frame, to the experienced traders looking for quick scalps on the 1 or 5 min, this tool is a great addition to any trader's toolbox.
Labels: Technical Analysis
