Would you like to know when the price of the stock you are trading is likely to find support or resistance and about to reverse? Yes? Great! You are in luck that J. Welles Wilder Jr. worked hard to write a book called New Concepts in Technical Trading Systems, where he explicitly introduced a technical indicator that does exactly that. It is called the Parabolic SAR, which stands for Stop And Reverse.
Today, we are going to show you what the Parabolic SAR is, how it is calculated, and how you can include the Parabolic SAR into your day trading strategy.
Figure 1: Parabolic SAR is plotted on the Price Chart as Dots that Appears Above or Below the Bars
If you have a good pair of eyes, you can identify the Parabolic SAR indicator from across the room. Most popular charting packages include the Parabolic SAR and it is plotted on the price chart of the stock as dots that appear above or below the candlesticks or bars.
During an uptrend, you will find that the Parabolic SAR dots appear below the price. On the other hand, when the price remains in a bearish trend, you will find that the Parabolic SAR dots appear above the price.
If you pay attention to Figure 1, you would find that the Parabolic SAR dots converge with the price momentum. Meaning, when you see a strong trend and price is going up or down quickly, the gaps between the dots will widen. By contrast, when the price is consolidating within a range, you would find that the Parabolic SAR dots are plotted close to each other.
Understanding the Parabolic SAR Formula
Well, you really do not need to know the actual formula of any technical indicator in order to build a trading strategy, but it pays to fully understand why those Parabolic SAR dots appear. Also, if you want to build a Parabolic SAR calculation excel file to build a decision support system for your day trading, you would need to know the Parabolic SAR formula.
Anyway, here is the formula that is used to calculate the Parabolic SAR values:
SARn+1= SARn + α (EP – SARn)
In the Parabolic SAR formula, the SARn is the current period and as +1 indicates, the SARn+1 is the next period’s SAR value. During an uptrend the EP is the highest price in the trend, which would be the high of the top most candlestick or bar in the trend. On the other hand, you can be pretty sure that the EP would represent the low of the lowest candlestick or bar in a downtrend.
Since the Parabolic SAR dots only appear either above or below the price, it is not a difficult task for you to identify what the EP value is representing. Right? If you still have any confusion, feel free to leave a comment and we would be happy to help you understand the formula better.
The most important variable in the Parabolic SAR settings is the α, which represents the acceleration factor in the formula.
When you try to add the Parabolic SAR indicator in the chart, your charting package would usually set the α value to 0.02. You see, during an uptrend or downtrend, when the price makes a new high or low, the acceleration factor is increased by 0.02. This is the reason why the gaps between the Parabolic SAR dots get larger during a strong trend and the size of the gaps contract during a price consolidation.
Although the default acceleration factor is set to 0.02, most charting packages would allow you to change it. You may wonder why you would ever need to fiddle with the acceleration factor. Well, some stock prices are more volatile than others and depending on the time frame you choose, optimizing the acceleration factor can indeed improve your trading performance.
For example, in the Tradingsim, you can replay the price action with different SAR acceleration factors in order to find the optimum value and forward test the market it to see if the new value makes any major difference in generating Parabolic SAR buy signals or Parabolic SAR sell signals. If you see a positive result, you should customize the SAR formula to fit the characteristic of the stock’s price action.
Example of Day Trading with Parabolic SAR Buy Signals
Figure 2: Parabolic SAR Buy Signals are Generated When the Price Moves Above the Upper Dot
Day trading with a Parabolic SAR strategy is pretty easy as these dots acts as dynamic support and resistance levels. During a downturn, the Parabolic SAR dots act as dynamic resistance levels and when the price moves above the upper Parabolic SAR dot, it generates a buy signal.
In figure 3, you can see that when Apple’s price was trending down on the 5-minute time frame, the Parabolic SAR dots went down with it and as long as the price did not move above the upper dots, the downtrend continued. However, when the price moved above the Parabolic SAR dot, the bearish momentum diminished from the market. Then, the Parabolic SAR indicator generated a buy signal that turned into a bullish trend.
Example of Day Trading with Parabolic SAR Sell Signals
Figure 3: Parabolic SAR Sell Signals are Generated When the Price Moves Below the Lower Dot
Similarly, you would find that during an uptrend in this 5-minute time frame of Apple Inc, the Parabolic SAR dots acts as dynamic support levels and when the price moves below the lower Parabolic SAR dot, it generates a sell signal.
In figure 4, you can observe that when the price was trending up, the Parabolic SAR dots went up along with it and as long as the price did not move below the lower dots, the uptrend prevailed.
However, as soon as the price moved below the lower Parabolic SAR dot, the bullish momentum diminished from the market and the Parabolic SAR indicator generated a sell signal. On this occasion, it was a small retracement, but nonetheless, you could have made quick profits out of this small swing.
Developing a Proper Parabolic SAR Strategy for Day Trading
If you understood how the Parabolic SAR indicator is calculated and how to properly apply a Parabolic SAR strategy in day trading, you should be very excited. However, you should also know that there are a few pitfalls to watch out for when you are depending solely on the buy or sell signals generated by the Parabolic SAR indicator.
First, due to the EP values, that measures the highest highs or the lowest lows during an uptrend and downtrend, respectively, the Parabolic SAR indicator generates the best signals during a trending market. But, when the market is consolidating, it would likely generate lots of false signals that can get you in trouble.
Figure 4: Including a Trend Strength Indicator like the DMI In the Chart Can Vastly Improve the Quality of Parabolic SAR Signals
Therefore, it is better that you consider including a technical indicator in the chart, which can measure the strength of the trend. For example, the Directional Movement Index indicator can show you if the stock is in a consolidation pattern or trending. This way, you can trust the Parabolic SAR buy or sell signals, and safely ignore the Parabolic SAR when the average line of the Directional Movement Index indicates a range bound market condition.
However, professional day traders often use the Parabolic SAR to set stop loss instead of generating buy or sell signals as well. If you are not sure about the trend’s strength, instead of placing a buy or sell order based on the Parabolic SAR signal, you can use the lower or upper Parabolic SAR dots as a trailing stop loss. Once the price moves above or below the dot, regardless if the price starts a new trend in the opposite direction or not, you can be certain that the prevailing trend is about to take a pause. It is always a smart idea to get out of the market at this point.
Conclusion
The Parabolic SAR indicator is a great tool to have on your day trading chart. If you develop a proper Parabolic SAR strategy around some of its pitfalls, you can improve the accuracy of your existing trend following strategy. In addition, by using the Parabolic SAR dots as a trailing stop loss for your open positions, you can easily figure out when the trend is likely to reverse and protect your profits.
Regardless how you choose to implement the Parabolic SAR indicator in your day trading, if you integrate it with other technical indicators, your monthly statement from the broker would likely make you just a bit happier, one dot at a time.
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