The parabolic Stop and Reverse (SAR), developed by Welles Wilder, is a trailing stop-based trading strategy that is frequently applied as an indicator. The SAR employs a trailing stop level, which tracks changes in price. The stop level increases speed according to an "Acceleration Factor."

This stop level resembles a parabolic curve when plotted on the chart. That's why it's known as parabolic stop and reverse. Parabolic functions accept three parameters. The first two parameters help manage the acceleration during up and down moves. The third variable defines the optimum acceleration.

The parabolic SAR predicts price to fluctuate over time because it is predicted that you are trading a trend. Regardless of whether the price has changed, the parabolic SAR will raise the stop every period if you are long. On the other hand, if you're short, the parabolic SAR curve moves downward.

How does parabolic Stop and Reverse work?

For computing the stop for each subsequent period, the parabolic SAR trading strategy employs the parabolic level as a "stop and reverse" point. When the stop hits, you may potentially close the current deal and start a new one. This technique keeps you continuously involved in the market.

Typically, the indicators appear as a collection of dots above or below the price bars. The stop levels can be seen as dots.

The parabolic SAR leads to whipsaws during trendless or sideways markets.

Fast-moving trends gain momentum as they develop and are where the parabolic SAR thrives. As a result, you may have the appropriate "Acceleration Factor" for the market you are trading because stops are also estimated to accelerate. Acceleration parameters for both up and down movements may differ.

Parabolic SAR Calculation

The parabolic SAR (PSAR) indicator helps in the determination of the position of dots by using the most recent extreme price (EP) and acceleration factor (AF).

The following equation helps in the calculation of the parabolic SAR:

Uptrend: PSAR = Prior PSAR + Prior AF (Prior EP - Prior PSAR)

Downtrend: PSAR = Prior PSAR - Prior AF (Prior PSAR - Prior EP)

Where:

AF = Default of 0.02, boosts by 0.02 for every new EP. The maximum value of AF is 0.02.

EP = Lowest low for a downtrend and highest high for an uptrend. It is updated for every new EP.

This calculation places a dot above or below the rising or falling price action (which can optionally be connected with a line). The dots highlight the current price direction. These indicators are known as "stop and reverse" because of their continuous presence. The dots flip on top of the price bars when the price drops below the rising dots. The dots flip below the price when the price rises through falling ones.

Parabolic SAR: Pros and Cons

The indicator's key benefit is that it will draw attention to significant trends, keeping traders focused on the trend direction. The indicator also offers an exit when any movement is in the opposite direction. In other cases, the price does reverse, making it a favorable exit. Other times, the price instantly starts to move in the trending direction again, making it a poor exit.

The indicator's major flaw is that it doesn't offer much analytical insight or reliable trade suggestions when the market is in a sideways trend. The indicator will frequently oscillate above and below the price in the absence of a defined trend. If a day trader simply depends on the parabolic SAR for trade signals, it could be a very losing day because this price movement can last all day.

To avoid trading against the trend, traders are advised to know how to identify trends. They could do so either through reading price action or with the help of another indicator.

How do parabolic SAR indicators help you set stop-loss order?

You can set your stop-loss at or just beyond the parabolic SAR depending on how much risk you're ready to take. When the trend is threatened, you can ensure the exit by setting it to the parabolic SAR. You can maintain your position in the event of fake-outs by setting your stop-loss order beyond the parabolic SAR, but you may potentially face the possibility of suffering a bigger loss.

What time period suits the parabolic SAR?

Like other charting indicators, the parabolic SAR performs effectively across all time frames. It would help if you considered your trading strategy while identifying the most suitable time frame. Swing traders may employ daily, weekly, or monthly time frames, whereas day traders may employ one-minute, five-minute, or one-hour time frames.

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