Indicators

Parabolic Stop and Reverse system

Overview
J Welles WIlder

Developed by Welles Wilder, the Parabolic SAR refers to a price and time based trading system. Wilder called this the “Parabolic Time/Price System”. In the system the SAR (“stop and reverse”) trails below prices during an uptrend and is above prices when prices are falling. The system calls for a stop and reverse when the price trend reverses and breaks above or below the indicator. The PSAR attempts to overcome a critical deficiency of many other trend following indicators, which forgo a significant amount of profitability of a trade due to the implied lag between the turning point and the trend-reversal signal. The term parabolic arises from the shape of the curve of the stops as they appear on the chart, with the stop being continually raised in a rising market and reduced in a falling market.

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Rising SAR

Prior SAR: The SAR value for the previous period.

Extreme Point (EP): The highest high of the current uptrend.

Acceleration Factor (AF): Starts at .02 (2%), AF increases by .02 each time the extreme point makes a new high, reaching a maximum of .20

Current SAR = Prior SAR + Prior AF (Prior EP-Prior SAR)

SAR can never be above the prior period’s low or the current period low. If this occurs use the lowest low over the 2 days as the SAR for the following day.

The trade is reversed when the price equals the SAR for the day.

Falling SAR

Prior SAR: The SAR value for the previous period.

Extreme Point (EP): The lowest low of current downtrend.

Acceleration factor (AF): Starts at .02 (2%), AF increases by .02 each time the extreme point makes a new low, reaching a maximum of .20

Current SAR = Prior SAR – Prior AF (Prior SAR – Prior EP)

SAR can never be below the prior period’s high or the current period high. If this occurs use the highest high over the 2 days as the SAR for the following day.

The trade is reversed when the price equals the SAR for the day.

 

Trading using the Parabolic SAR
 

Parabolic SAR follows price and can be considered a trend indicator. PSAR follows prices like a trailing stop, continuously rising as long as an uptrend remains in place, and continuously falling during a downtrend. The indicator acts as an effective guard against a trader’s propensity to move stop-losses. The PSAR will often perform poorly when the market is not trending producing frequent whipsaws, so it is advisable to deploy it in trending markets and combine it with other indicators to filter trades. Many traders will prefer to only use the PSAR for trailing stop losses during a trend, rather than deploy the ‘stop and reverse’ system. This can be advisable as many losing trades develop where traders go against the direction of the main trend, and strict use of the Parabolic SAR system can often result in trades counter to the dominant trend.

Parabolic SAR parameters: The Acceleration Factor (AF), referred to as the Step, dictates the SAR sensitivity. Traders can set the Step and the Maximum Step. The Step is a multiplier that influences the rate of change of the SAR. Wilder's system increased the Step parameter until it hit a maximum of 0.20.

SAR sensitivity can be increased or decreased by increasing or decreasing the step respectively. A higher step will result in a SAR that is close to the price action, making reversals more likely, meaning the trader may be whipsawed and fail to participate in large parts of the trend. Increasing the Step will insure that the Maximum Step is hit quicker when a trend develops. A lower Step moves the SAR further from the price making reversals less likely, the trade-off being that the trader risks leaving part of their profit behind. SAR sensitivity can also be adjusted using the Maximum Step, although the Step carries more weight as it sets the incremental rate of increase of the SAR as the trend develops. A lower Maximum Step decreases the sensitivity of the indicator resulting in fewer reversals.

Trade Signals

Trade signals are produced when the price crosses the PSAR indicator, squaring longs and going short when price falls below the SAR during an uptrend and covering shorts and going long when the price rises above the SAR during a downtrend. Strict use of the parabolic system necessitates buying/selling when the price crosses above/below the SAR, placing stops wells away from the trade point. A limitation of the SAR is that at this point the trader is exposed to significant risk until the price momentum increases and the parabolic begins to accelerate.