Parabolic SAR Indicator: What You Need to Know
Stock traders often use technical indicators to predict market trends and determine when to buy and sell securities. These indicators use historical data and time-tested models to increase the probability of securing profitable trades. The parabolic stop-and-reverse (SAR) indicator is one component of technical analysis you should consider adding to your toolkit. Understanding how this technical indicator works may help you with your stock trading, and it can also be useful for long-term investments.
What Is the Parabolic SAR Indicator
Technical analysts can use the parabolic SAR indicator to assess stocks and funds. Although useful, no indicator should be your sole guide, and it’s a good practice to combine multiple technical indicators before making a decision. The parabolic SAR indicator tends to give traders a better forecast during trending markets.
How to Calculate the Parabolic SAR Indicator
Many brokerage accounts that also have the option of trading stocks can automatically run these calculations for you. However, it may be useful to understand the math behind the parabolic SAR indicator. It can make the concept easier to grasp.
There are two distinct parabolic SARs uptrend and downtrend. And their formulas are slightly different:
Uptrend parabolic SAR = Prior SAR + Prior AF (Prior EP – Prior SAR)
Downtrend parabolic SAR = Prior SAR – Prior AF (Prior SAR – Prior EP)
Let’s break these formulas down:
Extreme Point (EP) refers to the highest price in an uptrend or the lowest price in a downtrend.
Acceleration factor (AF) refers to an arbitrary number set by the trader.
The maximum AF is 0.2 and for most calculations, it starts at 0.02. These are the default parameters, but traders can add a third parameter to the chart to adjust the increment amount. For the conventional approach, each time the stock price hits the prior EP, the acceleration factor increases by 0.02.
For example, if a stock’s current extreme point is $90, and the stock is priced at $88, the acceleration factor will jump from 0.02 to 0.04 if the stock exceeds $90/share. If the next extreme point gets established at $93/share, and the stock surpasses that value, the acceleration factor rises from 0.04 to 0.06.
What Does This Indicator Tell You
The SAR indicator can reveal strengthening trends and reversals. For instance, if a stock breaks past a support or resistance line, the trend is likely to continue. However, if the stock does not break past either of these lines despite getting very close, a reversal can be on the way. Having this insight can help you make decisions. Detecting trends before the stock market catches up can present profitable trading opportunities.
How Traders Interpret Parabolic SAR
When a stock’s price breaks through the downtrend parabolic SAR, some may view it as a buying opportunity. Traders may interpret this development as a reversal from prior declines. However, if a stock’s price breaks through the uptrend parabolic SAR, some traders may interpret it as an opportunity to sell the stock before more people do the same. When a stock falls below the uptrend parabolic SAR, it usually indicates more declines in the future.
When a downward parabolic SAR forms, an investor can opt against buying shares until the stock price crosses the downward parabolic SAR. Support and resistance lines are useful technical indicators, but it is more difficult to assess the stock when its price is in between support and resistance lines. Traders can wait for an intersection to get a better understanding of the trend. The intersection of a rising stock price and a resistance line may present a buying opportunity for the investor, as stocks usually continue moving up after breaking past resistance lines. While crossovers do not offer guarantees, many traders consider this phenomenon before buying and selling shares.
Other Indicators that Complement Parabolic SAR
Technical analysts look at multiple indicators before making a decision such as the Stochastic, Moving Average, and the Average Directional Movement (ADX) indicators. That’s because if you rely on only one indicator, you may miss the complete picture. Using a combination of these indicators along with the parabolic SAR Indicator may help with making smarter trading decisions.
Stochastic Indicator
The stochastic indicator can help identify when a stock is overbought or oversold. This indicator is measured with numbers between 0 and 100. A number below 20 indicates an asset is oversold, while a number above 80 indicates an asset is overbought. Some traders wait for the stochastic to drop below 20 before purchasing a stock to accumulate shares when the asset is oversold. Other traders may spot the opportunity and bid up the oversold stock’s price. However, stocks can remain overbought or oversold for an extended time, demonstrating the market’s irrationality even when a security appears to be overbought or oversold. No indicator offers a guarantee, but a stochastic below 20 or above 80 increases the likelihood of a reversal. An oversold stock can become less oversold as people buy shares, and an overbought stock can become less overbought as people sell shares.
Moving Average
The moving average is a line that measures a stock’s average price point over a set amount of days. Downward stock price movement will decrease the moving average, while any gains will increase the moving average. Sometimes a stock’s price crosses the moving average line. The direction in which the stock’s price crosses the moving average line determines whether the indicator hints at buying or selling the stock.
Traders may sell their shares if the stock’s price crosses below the moving average. This is a bearish signal that may trigger a reversal in the recent upward momentum. However, they may take a different approach and buy shares if the stock’s price crosses above the moving average line and continues to rise. Moving averages can help investors determine historical price movements and potentially capitalize on trends.
Average Directional Movement (ADX)
Traders who focus on technical analysis use various strategies to identify trends and make trades before the market notices, but some trends are stronger than others. The average directional movement (ADX) indicator can reveal the strength of a trend. This number ranges from 0 to 100 and can help traders determine whether a trend is a blip or has more weight to it.
An ADX above 40 highlights a strong trend, while an ADX below 20 demonstrates a weaker trend. In the sense, a few green days in the market may not demonstrate a meaningful trend if the ADX is below 20. To demonstrate that, the ADX should move closer to 40 before a trader may consider the current market trend to be reliable.
The ADX can help traders determine whether there is strength behind parabolic SAR crossovers or whether it makes sense to be skeptical. The ADX shows up alongside the positive and negative directional index lines. If the positive directional index crosses above the negative directional index, it may present a buying opportunity for traders.
Possible Advantages of the Parabolic SAR
The parabolic SAR can give you several advantages:
Help you detect trends
Help you determine potential exit and entry points
Receive signals about the possibilities of strong trend
Limitations of the Parabolic SAR
The parabolic SAR, like any technical indicator, isn’t perfect. While the parabolic SAR can help predict price trends, it isn’t as effective in a sideways market. The parabolic SAR accuracy depends on the trend’s strength. A weak trend is less likely to be accurate and may mislead traders.
It is also possible for a parabolic SAR reversal to take place even if a technical reversal does not. This is because of the acceleration factor in the formula that can yield premature reversals. Combining parabolic SAR with other technical indicators may help you calculate better.
Get Quicker Access to Technical Insights
The parabolic SAR indicator is one component of technical analysis. Using several technical indicators can help traders account for more scenarios. Technical indicators can feel overwhelming when you are getting started, but if you use a brokerage account that lets you access over 63 technical indicators and 38 drawing tools to discover new trends, technical analysis may be more manageable.
Frequently Asked Questions
1. Is parabolic SAR useful?
It can be if you use it alongside the right indicator, but there are no guarantees in the stock market.
2. Which technical indicators work with parabolic SAR?
Stochastic, moving average, and average directional movement are some indicators that can work well with parabolic SAR.
3. Which time frame is best for parabolic SAR?
Any time frame can work. It depends on what you feel comfortable with as a trader or investor.