January 28, 2024

Parabolic SAR

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The Parabolic Stop and Reverse (Parabolic SAR) is a popular technical analysis tool used for determining the momentum direction of an asset, as well as providing entry and exit points. Developed by J. Welles Wilder Jr., it’s particularly favored in trending markets.

Definition

The Parabolic SAR is a trend-following indicator and appears as dots or points on a chart. These dots are placed below price bars in a bullish trend and above price bars in a bearish trend. The indicator provides potential stop-loss points and can indicate a change in the trend direction when the price crosses these points.

Calculation

The calculation of Parabolic SAR is somewhat complex and involves several steps:

  1. Initial SAR: This is the most recent extreme point (EP) – the highest high in the current uptrend or the lowest low in the current downtrend.
  2. Acceleration Factor (AF): Starts at 0.02 and increases by 0.02 each time the EP changes, up to a maximum of 0.20.
  3. Next Period’s SAR: This is calculated by adjusting the current SAR by the current AF multiplied by the difference between the EP and the current SAR.The formula for an uptrend:

SARnext = SARcurrent + AF × (EP − SARcurrent)

For a downtrend, the formula is inverted.

Example

Let’s go through a simplified example:

  • Assume an asset in an uptrend.
  • Day 1: EP = $100, AF = 0.02, and SAR = $95.
  • Day 2: The price moves to $105, creating a new EP. The SAR for Day 2 is calculated using Day 1’s data.

Calculation for Day 2 SAR:

SARDay 2 = 95 + 0.02 × (100 − 95) = 95 + 0.02 × 5 = 95 + 0.1 = 95.1

If Day 2’s price is above 95.1 (which it is, as it moved to $105), the trend is still considered up.

Usage in Financial Analysis

  • Trend Direction: The position of the SAR dots relative to the price indicates the trend direction.
  • Stop Loss: The SAR can provide stop-loss levels; for example, in an uptrend, placing a stop-loss order just below the SAR dot.
  • Signal for Trend Change: When the price crosses the SAR dots, it may indicate a trend reversal.

The Parabolic SAR works best in trending markets but can produce false signals in ranging or sideways markets. It’s advisable to use it in conjunction with other indicators and tools for more reliable analysis.

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