Parabolic SAR - The Dots That Signal Trend Reversals
What is Parabolic SAR
Parabolic SAR is a trend-following indicator developed by J. Welles Wilder in 1978. SAR stands for Stop And Reverse, literally meaning "stop and reverse." This indicator is displayed as a series of dots on the chart, indicating the current trend direction and potential reversal points.
Wilder also developed RSI and ADX. The three indicators he developed have complementary relationships, so using them together can create synergy.
The biggest feature of Parabolic SAR is its visual simplicity. If the dots are below the price, it's an uptrend; if the dots are above the price, it's a downtrend. It's hard to find a simpler trend identification tool.
How to Read It on Charts
Parabolic SAR appears as a series of consecutive dots on the price chart. The position of these dots is key.
When Dots Are Below Price
When dots are plotted below the candles, it indicates an uptrend is in progress. In this state, you can maintain a long position or use the dot's position as a stop-loss level. As the trend continues, the dots gradually rise toward the price, following it.
When Dots Are Above Price
When dots are plotted above the candles, it indicates a downtrend is in progress. In this state, you can maintain a short position or use the dot's position as a stop-loss for short positions. As the trend continues, the dots gradually descend toward the price.
When Dots Flip
The moment when dots switch from below to above the price, or from above to below, is a trend reversal signal. This is the core concept of SAR (Stop And Reverse). It's a signal to stop the existing trend and reverse direction.
| Dot Position | Trend | Action |
|---|---|---|
| Below price | Uptrend | Hold long, use dots as stop-loss |
| Above price | Downtrend | Hold short, use dots as stop-loss |
| Flip from below to above | Bearish reversal | Exit long or enter short |
| Flip from above to below | Bullish reversal | Exit short or enter long |
Calculation Principles: Acceleration Factor
The calculation of Parabolic SAR uses a concept called the Acceleration Factor (AF). You don't need to memorize the complete formula, but understanding the principle helps predict the indicator's behavior.
SAR(tomorrow) = SAR(today) + AF x (EP - SAR(today))
Here's what each element means:
- SAR(today): Current SAR value (the dot on the chart)
- AF (Acceleration Factor): Starts at 0.02 and increases by 0.02 each time a new high (uptrend) or low (downtrend) is set. Maximum is 0.20
- EP (Extreme Point): The extreme value in the current trend. The highest high in uptrends, lowest low in downtrends
The key to this formula is the acceleration factor. If the trend continues and new highs or lows keep being set, AF gradually increases. As AF increases, the SAR dots approach the price more quickly. This is why the longer a trend lasts, the closer the dots get to the price, eventually causing price to touch the dot and trigger a reversal signal.
This is the origin of the "parabolic" name. The trajectory of the dots draws a parabolic shape.
Default Settings
| Setting | Default | Description |
|---|---|---|
| Starting AF | 0.02 | Initial value of acceleration factor |
| AF Increment | 0.02 | Increase when new extreme is set |
| Maximum AF | 0.20 | Upper limit of acceleration factor |
- Increasing the starting AF or increment makes dots approach price faster, making signals more sensitive.
- Decreasing the starting AF or increment makes dots approach slower, making signals more stable but slower.
- In volatile markets like cryptocurrencies, consider setting maximum AF lower than 0.20.
Using as a Trailing Stop
The most powerful practical use of Parabolic SAR is as a trailing stop. A trailing stop is a strategy that moves the stop-loss level along as price moves in a favorable direction.
Parabolic SAR naturally fits this role.
- After entering a long position, set the stop-loss at the Parabolic SAR dot's position.
- As price rises, the dots also rise, automatically adjusting the stop-loss level upward.
- When price falls to touch the dot, the stop-loss is triggered.
The advantage of this approach is that you can ride the trend as long as it continues while automatically exiting when the trend reverses. It provides an objective standard for traders who find it difficult to subjectively set stop-loss levels.
Advantages of Parabolic SAR
Clear Visual Representation
You can instantly identify the current trend direction just by looking at the dot positions on the chart. No complex calculations or interpretation needed. Dots below means uptrend, dots above means downtrend.
Excellent Performance in Trending Markets
In markets with strong uptrends or downtrends, Parabolic SAR captures most of the trend. As dots gradually follow the price, they often give accurate reversal signals precisely when the trend ends.
Provides Clear Stop-Loss Levels
The position of Parabolic SAR dots serves as the stop-loss level. It provides a clear answer to one of the hardest parts of trading: "where should I set my stop-loss?"
Limitations of Parabolic SAR
False Signals in Ranging Markets
This is Parabolic SAR's biggest weakness. In ranging markets where price moves up and down within a fixed range, dots frequently flip above and below, creating continuous false reversal signals. This is called whipsaw.
Following only Parabolic SAR signals in ranging markets leads to repeatedly buying then immediately selling, then buying again, accumulating commission losses.
Inaccuracy at Trend Reversal Beginnings
At the start of a trend reversal, the new SAR dot may be plotted quite far from the price. This means a wider stop-loss, so entering at the beginning of a reversal requires accepting significant risk.
Vulnerable to Gaps and Sharp Moves
Sharp price movements or gaps that frequently occur in cryptocurrency markets can trigger unexpected signals.
Overcoming Limitations with ADX Combination
Parabolic SAR's biggest weakness - false signals in ranging markets - can be largely resolved by combining it with ADX.
The method is simple:
- Check the ADX value to determine whether a trend currently exists.
- If ADX is above 25, a trend exists, so follow Parabolic SAR signals.
- If ADX is below 20, it's a trendless ranging market, so ignore Parabolic SAR signals.
| ADX State | Parabolic SAR Signal | Judgment |
|---|---|---|
| ADX > 25 | Dot flip occurs | Signal valid, follow trend |
| ADX 20-25 | Dot flip occurs | Caution needed, verify further |
| ADX < 20 | Dot flip occurs | Ignore signal, high probability of false signal |
Additionally, checking MACD direction or moving average alignment can increase the reliability of Parabolic SAR reversal signals.
Practical Application Summary
- Use with filters rather than alone: Don't make trading decisions based solely on Parabolic SAR; always use it together with ADX or other trend confirmation tools.
- Use as trailing stop: More effective as an exit criterion than an entry signal.
- Prioritize larger timeframes: False signals are more common on smaller timeframes, so using 4-hour or daily charts or higher is more stable.
- Recognize ranging periods: Always be aware that Parabolic SAR signal reliability drops during Bollinger Band squeeze periods or when ADX is low.
Parabolic SAR shines in trending markets. If you first assess market conditions and use it in confirmed trending periods, it can be a very useful trading tool.
Next article: RSI - The Indicator for Identifying Overbought and Oversold Conditions