Parabolic SAR

This to me is one of the most frustrating indicators in how it has been misunderstood.

Every YouTube video I see providing a explanation in error leading potential traders down the wrong road using this amazing little tool.

I have read and heard this called a trend following indicator, a reversal indicator and more. Then I sit and watch the videos and shake my head in fear for the traders who may use this improperly.

So, let me get away from being critical to explaining the use.

SAR stands for STOP AND REVERSE. So, let us focus on that first word. STOP.

Every trader out there asks “Where do I place my stops?” And we try to figure out tons of fancy methods for placing stops and trailing stops. Well, once upon a time, in the not so distance past. A man by the name of J. Welles Wilder Jr developed a calculation (before computer trading systems allowed us to place electronic trailing stops) to provide a daily calculation for the stop and to adjust it as the trend continues to advance. So, without further words or ado…New Concepts In Technical Trading Systems, Section II, The Parabolic Time/Price System – J. Welles Wilder Jr

“The Parabolic Time/Price System derives its name from the fact that when charted, the pattern formed by the stops resembles a parabola, or if you will, a French Curve. The system allows room for the market to react for the first few days after a trade is initiated and the the stop begins to move more rapidly. The stop is not only a function of price, but is also a function of time. The stop never backs up. It moves an incremental amount every day, only in the direction in which the trade has been initiated.”

That above is the opening paragraph of the section in which the Parabolic SAR is first presented. As you can immediately see, Mr. Wilder speaks nothing of the tool providing trend following or reversal or any such nonsense. But speaks profoundly of the tool being used for STOPS.

The starting point for the dots is the extreme from the previous SAR range. And in giving so, it will always be the highest high or the previous range or the lowest low.

The dots then being moving at an acceleration factor (AF) of .02 which is added back to the SAR. The AF is increased (by its own value of .02 until a value of .20 is reached) each day a new high is made (during a bull trend) or new low is made (during a bear trend).

One of the rules I find interesting; “Never move the SAR into the previous day’s range or today’s range.”

If the calculation catches up to the prices, however the prices are still trending, the following rules then take effect.

“If Long, never move the SAR for tomorrow above the previous day’s low or today’s low. If the SAR is calculated to be above the previous day’s low or today’s low, then use the lower between today and the previous day as the new SAR. Make the next day’s calculations based upon this SAR.”

“If Short, never move the SAR for tomorrow below the previous day’s high or today’s high. If the SAR is calculated to be below the previous day’s high or today’s high, then use the higher high between today and the previous day as the new SAR. Make the next day’s calculation based upon this SAR.”

What this is demonstrating is that after the trend gets moving, as long as it is still moving in the proper direction and hasn’t stalled yet. The HIGH or LOW from previous price bars becomes the new SAR. Keeping in with the expression of “breaking of the highs” or “breaking of the lows” for exit points.

“This system is a true reversal system; that is every stop point is also a reverse point. We will therefore call each stop point a SAR, which stands for STOP AND REVERSE. “

In 1978, the “REVERSE” may have been true. Especially when you look at the calculation.

Where is this “REVERSE” helpful?

If you are using a MA to help identify your trend. You realize there are times when you may have missed an entry and are looking to get into an investment. This “REVERSE” may help.

As the SAR moves closer to the prices, it may be triggered during a stall/profit taking session. This may last for several days. Should you interested in investing in this instrument, then wait for the trend to resume when it violates the SAR again returning in the direction of the trend.

How? Place limit orders for entry. And every day you can adjust the limit order in accordance with the new SAR.

Once you are entered in – you can then start placing your STOP position based on the SAR.

Summary: SAR is a stop/entry tool. It will help you lock profit in as you adjust your STOP with the SAR – allowing movement in the beginning and then tightening up the further the trend runs. You can also use the SAR to help you enter back into a trending movement after a session of profit taking has occurred. When used properly with a MA that is defining your trend, this will help you lock in profit and gain entry into a trend after it has established itself. Also, it helps you from losing money if you limit an entry and the price established the opposite trend. You are not losing out as it moves away from you.