Parabolic SAR: Trend master of different markets

 

The Parabolic SAR is a good trend indicator that helps an investor determine swings in bearish and bullish trends. A good investor will know how to read SAR’s readings and when to trust them. As long as one follows the appropriate strategies, few lag-based trend indicators can out-do the famous Parabolic SAR.

What is parabolic SAR?

The parabolic Stop and Reverse (SAR) is a trend indicator that generates buy and sell signals for investors. These signals allow an investor to better utilize trends to maximize their investment returns. Though their full name is Parabolic SAR, they are often referred to as SAR. An investor will get good returns from reading the following guide on the use of SAR. This guide is especially useful for those investors that operate in markets with a lot of trend shifts.

How does one calculate SAR?

Though knowing the calculation of SAR is not a requisite for using the tool, but it is still a good intellectual exercise. The formula for SAR is as following

Source: https://tradingsim.com/blog/parabolic-sar/#Parabolic_SAR_Formula

Hear n is the nth time period

EP represent extreme values. These are the highest prices in an uptrend and the lowest prices in a down trend.

or alpha represents the acceleration factor.

So essentially SAR for the next period is the previous SAR value plus the adjusted acceleration factor. This acceleration factor is adjusted for changes in extreme values. These changes in extreme values can be considered to be proxies for trend shifts. Now one can move towards reading of the SAR indicator.

How to read SAR indicator?

An investor can only use SAR as part of their investment strategy if they know how to read SAR. In order to use SAR an investor must know when the market is issuing buy or sell signals. An SAR issues a buy or sell signal on the basis of whether it is above or below a price candle. If the SAR is above the price candle, then it generates a sell signal. Therefore, the price of the asset is expected to fall within the coming time periods. Unless an investor aims to short that asset, they should sell it. The same happens for buying signals. When SAR is below a price candle, then it indicates a buy signal because SAR predicts that the price of that asset will increase in the near future. If one looks at the image below, all the SAR values highlighted in the red circle are buy signals while all the values in the red circle are sell signals

 

Source: https://www.youtube.com/watch?v=rtmEb2XQ9lE

As one can see, the SAR does a good job of predicting price rise and fall during trends. Therefore, it allows the investor to pick their entry and exit points in a trend. With this basic information, an investor can implement multiple strategies.

What strategies can one use with SAR?

SAR allows one to implement many useful strategies. Below we will discuss three of the most useful strategies for SAR.

Using SAR as a stop loss: SAR has a tendency to generate buy signals when it is below a price candle. Moreover, it will generate a sell signal when it is above a price candle. These characteristics resemble another beloved tool of investors. That tool is the stop-loss order. Investors use stop-loss orders to protect themselves from sudden downward movements in price. An investor will place a lower stop loss against price decrease when the market is an up-trend. Similarly, an investor will place the stop-loss above the price in a down-trend[1]. This means that SAR can become a good proxy for the stop-loss orders. By having the SAR as their stop-loss mechanism, the investor can be rest assured that their mechanism will adapt to the changing trends of the market.

Using it to decide when to exit a trend: Knowing the time of entry and exit into trends is an art that has turned prudent investors into rich men. Investors can use SAR to decide their point of entry into the market. E.g. in the image below, it is best to enter the market when the SAR “flips” i.e. it starts to show up on the bottom of the candles rather than above them.

Notice that the point of entry is the flip point as well Before this point, the SAR remained above the price candles.

The red marked point is the point of entry for the investor where as the blue circle will become the point of exit. With this entry and exit, one can see that the SAR allowed the investor to capitalize on the bullish run within the market.

Using it with ADX when dealing with oscillating (a.k.a choppy) markets- The above strategies are offensive strategies. These strategies allow the investor to maximize their gains. However, some strategies are more defensive. They ensure that the investor does not lose because of using a tool.  Like all tools, SAR has its weaknesses as well. It seems that when it comes to assessing short-term measures, SAR does not do a really good job. So just like with other tools, prudent investors use other tools to counter balance this weakness. This can be done with another trend indicator such as ADX. The strategy relies on confirming one tool’s move with another. So, if ADX validates SAR’s prediction then one should go with SAR, however if ADX goes against SAR, then its probably best to err on the side of caution. In the following image, we can see that ADS has been plotted alongside SAR.

Note: the +DX and -DX lines have been purposefully omitted in order to make the analysis simple and concise.

In the above image it is very clear that the ADX does confirm the reading of SAR. As we can see there is a “flip” in the readings for SAR at the point of the red circle. At around the same instance, we can see a reversal in the ADX (which is marked by the blue circle). ADX and SAR will remain fellows of the same boat for long-term trend detection. The problem comes with oscillating short-term market.

In the image below, we can see that the SAR is giving its usual confusing signals for the short-term.

However, if the investors take into account the ADX values, they can see that all these signals are noise rather than reverse signals. Therefore, the ADX can act like a detector for when one should listen to the SAR indicator and when can one ignore the buy and sell signals of SAR.

What are the advantages of the SAR indicator?

The SAR indicator has many unique characteristics that help it stand above from other technical indicators. First of all, SAR indicator allows an investor to determine his entry and exit points into the market. By identifying entry points, the investor can help exploit potential opportunities. Whereas the exit points will help them guard those gains from market volatility. Secondly, by becoming a good stop-loss mechanism, SAR allows an investor to better automate their trading.

What is the weakness of the SAR indicator?

The art of using any technical indicator lies in knowing the weakness of the tools that one is using. That also stands true for SAR. SAR indicator has two major weaknesses.

“Always trend” assumption: – First, SAR stands for stop and reverse. The measure itself is built on the assumption that market is either in uptrend or down trend. This is not always true. Generally, the market can be either in trend (bearish or bullish trends), stationary or in small oscillations. When the market is stationary the price chart moves laterally (i.e. price remains stable in relation to time) rather than going up or down. This is a very common occurrence in modern markets. Therefore, SAR performs really poorly in such conditions. SAR’s performance does not improve by much when it comes to low oscillation markets. E.g. if you look at the image below you can see a small oscillation market.

Now the SAR shows buy and sell signals consecutively. However, as we can see the investor will not have gained a lot by following the advice of the SAR signal. Perhaps after taking the transaction fees into account, this might even become trades with negative net returns.

Lag measure: – Second SAR is a lag measure. This means that SAR will signal the presence of a trend only after it has been initiated. A good example lies in the following image

In the above image one can see that the investor has missed out on the first major price rise (indicated by the red circle).

This can be an issue in case we have a market that quickly seizes new trading opportunities. However, such a weakness can be countered by coupling SAR with some other tool such as Bollinger bands and ADX. Moreover, this will not be a major issue for long term traders.

Conclusion

SAR can be a really good tool in the hands of a skilled trader. Though it has many pitfalls but its ability to spot entry and exit points in trends is unmatched. However, like all tools, SAR works best when used with other tools. Any wise investor will happily include SAR in their arsenal of technical investment tools.

[1] The assumption is that this investor is shorting the asset during the bearish run.