What is the Parabolic SAR Indicator?

Pattern-based signals and mathematical calculations that appear on a trading chart for use in technical analysis are known as Technical indicators. These signals are produced using data from price, volume, and open interest on an asset price. Technical analysts often employ technical analysis theories in conjunction with the indicators to determine profitable entry and exit trading points.

Created by J Welles Wilder, the Parabolic SAR Indicator is a technical indicator that employs principles of technical analysis to guide traders and investors in decision-making. In this article, we discuss the ins and outs of the Parabolic SAR Indicator and explore its use within the cryptocurrency market.

What is the Parabolic SAR Indicator?

Also referred to as the stop and reverse system, the Parabolic SAR is a technical indicator that works to predict the price movement of an asset. The Parabolic SAR Indicator is often applied together with a trading strategy to make decisions on profitable entry and exit trading points for an asset.

Welles Wilder, the creator of the Relative Strength Index (RSI), also developed the Parabolic SAR Indicator as a versatile technical tool for use across various financial markets, including the cryptocurrency market. On an asset trading chart, the Parabolic SAR Indicator appears as a series of dots, which point to the bullish or bearish signals in the price movements of an asset. However, the indicator goes beyond identifying trends to specify the most profitable exit and entry points.

How does the Parabolic SAR Indicator Work?

The Parabolic SAR is represented on a market chart as a series of dots that run below or above the price action of an asset. The dots serve as a mechanism for highlighting buy or sell signals. Essentially, when the PSAR dots are below the price but moving upwards, the price action is said to be in an uptrend. When the factors are in reverse, there is said to be a downtrend.

In a trend and reversal trading strategy incorporating the PSAR, traders often buy when the dots are below the price and pointing upwards. This refers to a bullish trend, and the greater the slope of the PSAR dots, the stronger the trend. Conversely, traders sell when the dots appear above the price, moving downwards. This is known as a bearish trend. The same rule governing the slope in an uptrend appears here.

The Parabolic SAR Indicator is a reliable technical analysis indicator that is best applied in markets with easily recognizable trends. In a sideways market (where the price frequently moves up and down), the recommended action is to wait until the market breaks out in a clear direction. The indicator can produce false signals during a sideways market by frequently moving across the price. The noncommittal nature of the market leads to many extremes and comprises the reliability of the PSAR.

Source: FxLeaders

Calculating the Parabolic SAR Indicator

In light of recent technological advances, manual calculation of the Parabolic SAR Indicator has become somewhat obsolete. Trading consoles across digital representations of financial markets often have a feature that automatically calculates most technical indicators.

Nevertheless, the formula for calculating the SAR (stop and reverse points) is crucial to understanding the technical indicator.

Existing market data is crucial to calculate the Stop and Reverse points using the Parabolic SAR. Often, traders will use data on the previous day to calculate the SAR points for the current day, and so on.

Before calculating the Parabolic SAR of the current day, the following data is required:

• Prior PSAR: The Parabolic SAR value from the previous trend.
• Prior Extreme Point (EP): This refers to the highest and lowest points set in the trend.
• Acceleration Factor (AF): The acceleration factor starts at .02 and increases by .02 each time the asset’s price reaches a new extreme point. The maximum AF is .20, regardless of how long the uptrend lasts.

Where the asset prices are on the rise, it is referred to as an uptrend and the EP value used is the highest point of the trend. The formula for calculating the Parabolic SAR for an uptrend is thus:

Prior PSAR + Prior AF * (Prior EP - Prior PSAR)

In a downtrend, the EP represents the lowest point of the trend and the formula is as follows:

Prior PSAR - Prior AF * (Prior PSAR - Prior EP)

Pros and Cons of the Parabolic SAR Indicator

Since its development, the Parabolic SAR Indicator has been used by traders across various financial markets. Over the years, the PSAR has been favored because of its ability to accurately identify a price trend. In a strong trend, the PSAR helps the trader to stay abreast of price movements, providing exit signals when there is a chance of a price reversal. A recent study showed that the Parabolic SAR guaranteed an 80% return in a bullish trend lasting over five years. Whether used alone or as part of a larger trading strategy, the PSAR greatly increases an investor’s chances of noting profitable buying and selling points.

On the downside, the PSAR has been known to lack credibility in a choppy market (where there are quick dips and raises in asset prices). Where the market lacks a clear trend, the accuracy of the trend dips significantly, often providing misleading signals that could cause losses. In such a situation, the common recommendation is to first identify the strength of the trend with another indicator, such as a moving average, and only trade in the direction of a dominant trade. When there is no such trend, investors are advised to avoid trades.

Implementing the Parabolic SAR in Crypto Trading

Crypto markets are sometimes incompatible with historical technical analysis methods. The markets are known for volatility and long-lasting trends. As the PSAR’s biggest advantage is its efficiency when applied to markets with a strong trend, the PSAR and crypto markets go hand in hand.

Nevertheless, the most common recommendation for applying the PSAR to technical analysis for crypto trading is to include it as part of a larger trading strategy. A trading strategy can be formed by combining two or more technical indicators or using technical analysis tools.

Combining the Moving Average and the PSAR

The moving average is one of the technical analysis’s oldest and most efficient indicators. The indicator works primarily to identify the direction of a market and secondarily to identify price reversals. The moving average works similarly to the Parabolic SAR, making the two indicators an almost perfect fit for a trading strategy.

According to a recent study, combining both indicators produced a 95% confidence level. Standing alone, the MA failed to make a competing result.

As a result, traders have begun combining both indicators to include an added layer of certainty. The PSAR being made to work best in trending markets produces below-average accurate signals in sideways markets. The obvious solution is to introduce the MA, such that the PSAR buy signals are confirmed by the MA line (below price action), and sell signals are confirmed when the MA line rises above the price action.

Price Action Trading with Trend lines and the Parabolic SAR Indicator

At a very basic level, all trading techniques require traders to consider the price data available on the market. Price action trading is then a trading strategy that is executed by analyzing the price action of an asset over a while. This technique allows a trader to make informed decisions by first studying recent and past price movements. The strategy is rooted in technical analysis principles and is dependent on technical analysis tools like candle stick patterns and trend lines. Trend lines distinct lines draw on a market chart to determine the price direction of an asset. They are drawn across the highest highs or the lowest lows to show the prevalent price action.

In some cases, drawing the trend line is challenging, as spotting the higher lows can be somewhat difficult. This is where the SAR dots of the Parabolic SAR come in. The PSAR dots follow the price action, sometimes falling below or above the candlestick charts. A trend line can be formed by joining the progressive SAR dots that fall below the price action.

Conclusion

Considering its origins in the 1970s, Parabolic SAR is still widely used today. It can be applied to many of today’s investment options, including the Forex, commodities, stock, and cryptocurrency markets.

However, no market analytics tool can guarantee complete accuracy. Before employing Parabolic SAR or any other strategy, investors should ensure they understand financial markets and technical analysis. They should also have proper trading and risk management strategies in place to mitigate the risks that are unavoidable.

Data Sources

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https://www.investopedia.com/trading/introduction-to-parabolic-sar/#:~:text=The%20parabolic%20SAR%20is%20a,relative%20strength%20index%20(RSI))

https://www.investopedia.com/ask/answers/06/parabolicsar.asp

https://www.thebalancemoney.com/parabolic-sar-trading-1031198

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