In the world of short-term trading, experiences are defined by a trader's ability to anticipate a certain move in the price of a financial asset. There are many different indicators used to predict an asset's future direction, but few have proved to be as useful and easy to interpret as the parabolic SAR. In this article, we'll take a look at the basics of this indicator and show you how you can incorporate it into your trading strategy.
The Indicator
The parabolic SAR is a technical indicator that is used by many traders to determine the direction of an asset's momentum and the point in time when this momentum has a higher-than-normal probability of switching directions. Sometimes known as the "stop and reversal system", the parabolic SAR was developed by the famous technician Welles Wilder, creator of the relative strength index, and it is shown as a series of dots placed either above or below an asset's price on a chart.
One of the most important aspects to keep in mind is that the positioning of the "dots" is used by traders to generate transaction signals depending on where the dot is placed relative to the asset's price. A dot placed below the price is deemed to be a bullish signal, causing traders to expect the momentum to remain in the upward direction. Conversely, a dot placed above the prices is used to illustrate that the bears are in control and that the momentum is likely to remain downward. (For further reading, see How is the parabolic SAR used in trading?)
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The first entry point on the buy side occurs when the most recent high price of an issue has been broken; it is at this time that the SAR is placed at the most recent low price. As the price of the stock rises, the dots will rise as well, first slowly and then picking up speed and accelerating with the trend. This accelerating system allows the investor to watch the trend develop and establish itself. The SAR starts to move a little faster as the trend develops and the dots soon catch up to the price action of the issue. As you can see in Figure 1, the indicator works extremely well when a stock is trending, but it can lead to many false signals when the price moves sideways or is trading in a choppy market.
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Parabolic SAR and the Short Sale
The parabolic SAR is extremely valuable because it is one of the easiest methods available for strategically setting the position of a stop-loss order. As you become more acquainted with technical indicators, you'll find that the parabolic SAR has built up quite the positive reputation for its role in helping many traders lock-in paper profits that have been realized in a trending environment. You can also see that professional traders whoshort the market will use this indicator to help determine the time to cover their short positions. (For more, see Trailing-Stop Techniques.)
The parabolic SAR is extremely valuable because it is one of the easiest methods available for strategically setting the position of a stop-loss order. As you become more acquainted with technical indicators, you'll find that the parabolic SAR has built up quite the positive reputation for its role in helping many traders lock-in paper profits that have been realized in a trending environment. You can also see that professional traders whoshort the market will use this indicator to help determine the time to cover their short positions. (For more, see Trailing-Stop Techniques.)
It is important to note that this indicator is extremely mechanical and will always assume that the trader is holding a long or short position. The ability for the parabolic SAR to respond to changing conditions removes all human emotion and allows the trader to be disciplined. On the other hand, the disadvantage of using this indicator can also be seen in Figure 1. Notice how the signals can lead to many false entries during periods of consolidation. Being whipsawed in and out of trades can often be extremely frustrating, even for the most successful traders.
