PARABOLIC SAR INDICATOR EXPLANATION AND CALCULATION
Introduction & Explanation:
Parabolic SAR is a trend following indicator and is also popularly used by traders to set trailing stop losses.
The indicator was developed by Welles Wilder, who also developed and introduced the Average True Range, RSI and Directional Movement (ADX) to the public in the late 1970s. All these indicators are still widely used today.
Parabolic SAR was originally called “Parabolic Time/Price System”, where SAR is an acronym for “stop and reverse”. Technical analysts often refer to the indicator simply as “SAR” per se.
Part of the indicator’s popularity stems from its ease of interpretation. It is characterized by using dots instead of lines, ranges or “clouds” to convey information on the chart.
Points that form below the price and rise in an upward sloping pattern indicate an uptrend. Points that form above the price and fall in a downward sloping pattern indicate a downward trend. They can also represent the price at which a trader might set a trailing stop, depending on whether SAR is used for this purpose.
CALCULATION OF THE PARABOLIC SAR INDICATOR
Rising parabolic SAR value
In general, we have three elements – the prior SAR value and two indicator-specific values known as extreme point (EP) and acceleration factor (AF).
The prior SAR value is simply the SAR value of the previous period.
The extreme point (EP) is the highest value of the prevailing upward trend.
The acceleration factor (AF) starts at 0.02 in the default settings of the indicator and increases by 0.02 when the extreme point (EP) reaches a new high. Its maximum value is 0.20, regardless of how many new highs the extreme point reaches.
The value of the acceleration factor – both the rate at which it can increase and its maximum value – can be adjusted in the charting platform settings.
In the SAR calculation formula, the current SAR is calculated by adding the previous SAR to the product of the previous acceleration factor and the difference between the previous extreme point and the previous SAR:
Decreasing parabolic SAR
The three elements remain the same – we use the previous SAR, the extreme point (EP) and the acceleration factor (AR).
They are combined very similarly in the SAR formula, except that the second part of the formula is subtracted rather than added.
Current SAR = Previous SAR – Previous AF * (Previous EP – Previous SAR)
INTERPRETATION OF THE PARABOLIC SAR – TRADING STRATEGIES
The parabolic SAR effectively works like a “trailing stop loss”. In uptrends, SAR works to gradually “capture” gains (or move the stop loss closer to breakeven) based on its position below price. Many traders use SAR for stop loss purposes and is largely its primary application.
For example, if we are trading on the daily chart of the EUR/USD and currently have a long position in the market, we could set our stop loss at the price level dictated by the SAR.
Depending on the trend, the SAR can be close or far from the price. On this particular 15-minute chart of the EUR/USD, the SAR is less than one point (or less than 0.04%) away from price, which makes triggering the stop loss quite likely (image above).
Overall, this stop loss will continue upwards as long as the uptrend remains. Once the price breaks below the SAR in an uptrend or above the SAR in a downtrend, the indicator reverses.
Accordingly, we never see a decrease in SAR in an uptrend or an increase in a downtrend and continuously shift with each period to protect all profits from a trade.
The parabolic SAR can also be used as a trend following indicator in its own right. Traders using it in this sense will usually bias their trades to the long side when the parabolic SAR is at levels below price (i.e., in an uptrend). Similarly, they might bias their trades to the short side when the parabolic SAR is at levels above price (i.e. in a downtrend). However, like all indicators, they should not be used in isolation and alongside other technical tools and analysis methods.
Adjusting the Parabolic SAR settings
The rate of change of the parabolic SAR depends on the acceleration factor (AF), hence its name as such. The settings of the AF can be adjusted, which is referred to as the step.
The default setting for the step is 0.02. Its maximum value is 0.20 by default and is also adjustable.
The rate of change of SAR, sometimes called sensitivity, can be changed by lowering the step. This works by increasing the distance between SAR and heading. The SAR reverses when the heading touches its level. Therefore, if the SAR is further away from the price, the indicator is less likely to reverse.
Take a look at this example of the S&P 500 daily chart using the default settings (0.02 start, 0.20 maximum).
And let’s compare this with different settings of a 0.01 start and a 0.20 maximum.
We see that the trend is less likely to move back and forth.
In contrast, the rate of change of SAR can be increased by increasing the step (start). This causes SAR to move closer to the price, making a reversal of the indicator more likely. Here we have the settings of 0.04 in the step and 0.20 in the maximum.
We see a larger number of reversals and also the SAR further away from the price.
The sensitivity also decreases when we lower the maximum. If we reduce it from 0.20 to 0.04, we see that trend changes are less likely. The maximum is more easily reached when it is set to lower values. In this case, it is less likely to change and we see less sensitivity. Also, the SAR value remains further away from the price.
What are the best settings?
Of course, there is no right answer to this. For those who want tighter stops to more easily protect profits or limit price declines, it would be best to have a higher level and maximum.
For example, settings of 0.05 for the start and 0.40 for the maximum would give fairly tight stops as represented by the height of the SAR point and its proximity to the price.
These settings would also be relevant for those who use the parabolic SAR as a trend following indicator and prefer the indicator to have higher sensitivity and thus more frequent changes.
For those who want more accommodating stops to avoid premature termination and allow “breathing room” in their trades, a lower level and maximum would be appropriate.
In this case, settings of 0.01 for the start and 0.02 for the maximum would provide for looser stops.
Those using the parabolic SAR for trend following might also prefer this setting to get a broader view of the trend, rather than a setting that oscillates more frequently than higher level and maximum values.
Conclusion on the Parabolic SAR Indicator:
The parabolic SAR is regularly used to track trends. It also serves as a guide to where traders should place their stop loss to limit downside movement and/or protect the profit associated with their trades. The progressive point configuration of the indicator works very similarly to the adjustment of a trailing stop.
The settings of the indicator can be adjusted from its start and maximum values of 0.02 and 0.20, respectively.
Those who wish to increase the sensitivity of the indicator – resulting in more frequent trend changes (as diagnosed by the SAR value) and tighter trailing stops – should increase the start and maximum values.
Those who want to decrease the sensitivity of the indicator – less frequent trend changes and looser trailing stops – should decrease the step size and maximum value.
The settings should be evaluated for each individual security and in accordance with one’s trading preferences. There is, of course, no right answer as to which settings are best. The default settings are, of course, the most commonly used.
Like all indicators, this one should never be used in isolation. Developing a complete trading system requires the use of multiple modes of analysis (technical analysis), from looking at price trends and/or other technical indicators to fundamental analysis.