The parabolic SAR - also known simply as SAR or “stop and reverse” - is a popular indicator used to gauge and possibly ride trends. It was first introduced by the prolific trader and technical analyst J. Welles Wilder, also the father of the Average True Range (ATR), the Relative Strength Index (RSI), and the Average Directional Index (ADX).
Its formula changes depending on whether the market is trending up or down:
- - Uptrend: PSAR = Prior PSAR + Prior AF (Prior EP - Prior PSAR)
- - Downtrend: PSAR = Prior PSAR - Prior AF (Prior PSAR - Prior EP)
- EP = This is the highest high for an uptrend and lowest low for a downtrend
- AF = A default value of 0.02 which rises by 0.02 each time a new EP is reached up to 0.20.
While the mathematics behind this indicator is rather complex, the SAR is one of the easiest indicators to visualize and use, which partly also explains its popularity.
Graphically, the parabolic SAR appears as a dot either on top of price candlesticks - indicating the price is moving downwards - or below, in which case prices are nosing up. As the dot changes side, so does the direction of the price. (Assuming the indicator is not producing a false signal, but more on this below.)
The Parabolic SAR, shown as a line of dots above or underneath the candlesticks
The easiest way to use this indicator is therefore to monitor the parabolic SAR and place a buy order when the dot shifts below the candlestick and a sell order when the dots appear on top of it.
Well, not so fast. Whereas the parabolic SAR is intuitive and can be used profitably, it is prone to provide fake signals in sideways markets.
A series of wrong signals can be produced in consolidating markets
It’s all about the trend
What makes the difference between good and poor performance with the parabolic SAR is whether the market is trending or not. Just like many other indicators, and possibly even more than in other cases, the parabolic SAR suffers sideways markets and is liable to producing streaks of wrong signals as the price bumps up and down within a price channel.
It is great for riding trends, however, making for a great tool to use during a breakout.
This is why the Parabolic SAR is typically used in combination with trend indicators, including the ADX and moving averages.
Combination 1: Parabolic SAR and the ADX
The Average Direction Index (ADX) is the natural complement of the Parabolic SAR, being one of the main trend indicators. The ADX measures the presence and intensity of trends, with a reading above 25 indicating a significant trend and one above 50 hinting at a very strong direction in the markets.
Coupling it with the parabolic SAR and entering trades only when the ADX shows the trend is on can be an effective way to avoid getting enmeshed in phases of consolidation that would bring about false signals. (Which does not mean you cannot trade sideways markets, just that the parabolic SAR is not the most effective indicator in such conditions.)
Combination 2: Parabolic SAR and moving averages
Moving averages are the number one tool used traders to find where the market is trending. As such, they make for a great combination with the aprabolic SAR. Given the number of moving averages out there, we will not enter into this topic right now, but in general working with a moving average - or even better, a set of them - to find out the trend can be highly convenient.