Definition
The Parabolic Stop and Reverse signal abbreviated as SAR, is a technical indicator used to predict short-term trend direction, potential reversals in price and provide signals for exit and entry points.
On a chart, the indicator is represented by a series of dots, either above or below an asset’s price, depending on the direction the price is moving. Dots will be placed below the price when the asset is trending upward (Bullish) or above the price when the asset is trending downwards (Bearish).
When the price of an asset rises or falls, the dots will correspondingly rise or fall as well. The rate at which the dots rise or fall will vary over time. This process will usually see the SAR’s rise or fall starting off slow but then moving faster as the trend develops, with the dots eventually catching up to the price of the asset itself.
Signals
When the dots are above the price, the market is in downtrend, indicating that you should be short. When the dots are below the price, the market is in an uptrend, indicating that you should be long.
When the dots flip, opposite to their previous position (Above or below the asset’s price) this indicates that the direction of price will reverse soon. For example if the dots are above the price, when they flip below the price, this signals a future rise in price and hence a buy signal. Alternatively if the dots are below the price but flips above the price, this signals a future fall in price and hence a sell signal.
Stop Loss
The parabolic SAR will often be used for setting stop-loss orders. Many traders will choose to move their trailing stop loss order to match the level of the SAR indicator. This is because a move beyond this level will signal a reversal, causing the trader to anticipate a move in the opposite direction.
In a sustained trend, the parabolic SAR will usually be far enough removed from price to prevent the trader from being stopped out of a position from temporary fluctuations, enabling the trader to ride the trend for a long time.
Conjunction with other indicators
The indicator is most commonly used in trending markets with long rallies or declines and in conjunction with other indicators. The SAR would be used predominantly as identification for the security’s trend direction with the other indicators used to find the strength of the trend itself. Regardless, in trading, it is always good to have several other indicators confirm a certain signal that you are looking at.
Wilder, the creator of the parabolic SAR, recommended using other indicators such as the average directional index momentum indicator to confirm the strength of the existing trend. Other indicators that complement the SAR trading signals include stochastic and moving averages.
For example, when the price is trading below a long-term moving average, SAR sell signals are more convincing and when prices are above the moving average buy signals are more convincing.
Limitations
The SAR can lead to false signals in markets whereby the asset’s price moves sideways and the market is choppy. Because there is no consistent trend present, the indicator will constantly alternate above and below the price. Traders should therefore only trade in the direction of the dominant trend and avoid trades where a trend is absent.
