Key takeaways
- The Parabolic SAR helps traders identify potential trend reversals by placing dots on a price chart and is most effective when combined with other overlays or indicators.
- It was designed by J. Welles Wilder Jr. in 1978 and remains a staple in technical analysis.
- The overlay is especially useful in trending markets but can give false signals in choppy conditions.
- Adjusting the acceleration factor (AF) allows traders to tailor the parabolic SAR to their trading style.
The parabolic SAR helps traders identify potential trend reversals by placing dots on a chart — either above or below the price.
Short for “stop and reverse,” the parabolic SAR was designed to signal the point at which an asset’s trend is likely to reverse. By following the dots, traders can determine when to enter or exit a trade, helping them ride trends and avoid potential losses.
Trading tools such as the parabolic SAR are essential for making sense of the market’s movements. Indicators like RSI and MACD analyze price data to help spot trends or momentum shifts, while overlays such as moving averages and Bollinger Bands are plotted directly on the price chart to highlight key levels or patterns.
The parabolic SAR fits into the overlay category, as it’s plotted directly on the chart and provides visual signals to guide trading decisions.
Developed by J. Welles Wilder Jr. in 1978, the parabolic SAR was introduced in his book New Concepts in Technical Trading Systems. Since then, it’s become a staple in technical analysis, widely used across various markets, including crypto.
Using the parabolic SAR in stock markets
The parabolic SAR (stop and reverse) is a popular tool in trading in the stock market, but it has also been used in crypto markets. Understanding this in the context of the stock market is useful and gives a foundation for the cryptocurrency market explanation, which follows below.
The parabolic SAR helps traders spot potential trend reversals by placing dots — called the SAR — on a price chart. These dots are crucial because they tell you whether to consider buying or selling. When the dots are below the price, it’s a bullish signal, suggesting the market might go up. If they’re above, it’s bearish, indicating the market could drop.
This can be visualized by observing how the dots are placed on a sample AAPL stock chart.
The dots move along with the price, and they’re calculated using two key elements:
- The acceleration factor (AF)
- The extreme point (EP).
The extreme point (EP) is updated whenever a new high or low is reached within the current trend. This ensures that the parabolic SAR always uses the most extreme price to help determine where to place the next dot on the chart. The EP influences the acceleration factor (AF), which controls how quickly the parabolic SAR dots move closer to the price.
As the trend strengthens and the price continues to hit new extremes, the AF increases, causing the dots to get closer to the price. This process helps the parabolic SAR respond more quickly to potential trend reversals, leading to the “stop and reverse” behavior when the trend changes.
While it might seem counterintuitive, rapid price increases can sometimes indicate that a trend is becoming exhausted or overextended. Additionally, rapid price movements often come with higher volatility, which can lead to sudden changes in direction. The parabolic SAR adjusts to these conditions to help traders manage their positions more effectively.
Let’s say you’re trading a stock that’s currently in an uptrend. The parabolic SAR has been placing dots below the price, indicating the uptrend is still in play:
- Day 1: The stock price reaches a new high of $100. The parabolic SAR updates the extreme point (EP) to $100. The dots are plotted slightly below the price, with a moderate acceleration factor (AF), indicating the trend is stable.
- Day 2: The price continues to rise and hits $105, setting a new high. The EP is updated to $105, and the AF increases slightly, bringing the dots closer to the price.
- Day 3: The trend strengthens further, and the price jumps to $110. The EP is now $110, and the AF increases more, making the dots get even closer to the price.
- Day 4: The price hits $115 but then suddenly pulls back to $108. Because the dots have been getting closer due to the increasing AF, the parabolic SAR is now closer to the price and may soon flip above it if the price continues to drop. This would signal a potential trend reversal.
In this example, as the stock price kept hitting new highs, the EP was updated, which in turn caused the AF to increase. This made the parabolic SAR dots move closer to the price, allowing the indicator to react more quickly to any potential reversal. When the price finally pulled back, the parabolic SAR was ready to “stop and reverse,” signaling that the uptrend might be ending and that it could be time to consider exiting the position.
For those who like to dig into the math, we’ll take a look at the formula later on.
Did you know? Alexander Elder is a well-known proponent of the parabolic SAR. Elder, a respected trader and author, has frequently discussed and advocated for the use of Wilder’s indicators, including the parabolic SAR, in his books and trading seminars.
Using the parabolic SAR in crypto trading
Applying the parabolic SAR in crypto trading is pretty straightforward, warranting a short tutorial with the help of a well-known crypto trading platform.
1. Adding parabolic SAR to your chart
Open your preferred trading platform (in this case, Bybit) and select the cryptocurrency pair you want to analyze. Locate the parabolic SAR overlay, usually found under the “Indicators” section. Apply it to your chart. You’ll see a series of dots appear, either above or below the price candles.
2. Interpreting buy and sell signals
Next, it’s important to figure out how the overlay conveys buy and sell signals to the user.
Buy signal: When the dots move below the price, it’s a potential buy signal. This suggests the market might be shifting to an uptrend.
Sell signal: Conversely, when the dots appear above the price, it signals a potential downtrend, indicating it might be time to sell.
3. Spotting trend reversals
The parabolic SAR is especially useful for identifying trend reversals in the crypto market, which is known for its sharp price swings.
Watch for the moment when the dots switch sides; this often marks the start of a new trend direction. However, given the crypto market’s volatility, it’s wise to use this in conjunction with other tools to avoid false signals.
4. Adjusting settings for your trading style
The default settings of the parabolic SAR might not fit every trading strategy.
For short-term traders, increasing the acceleration factor (AF) can make the overlay more responsive and capture quick trend changes.
Long-term traders might prefer a lower AF, making the overlay less sensitive to minor price fluctuations and more focused on the overall trend.
Bybit illustrates the AF as the “Step” and the EP as the “Maximum.”
Did you know? In volatile markets, adjusting the acceleration factor (AF) of the parabolic SAR can help make it less sensitive, reducing the chances of premature signals. A lower AF slows down the SAR’s responsiveness, which can be beneficial in avoiding false reversals.
Advantages and limitations of parabolic SAR
The parabolic SAR is a popular tool for good reason. However, it’s not a solution for all.
Advantages of using parabolic SAR in crypto trading
- Simplicity and clarity: One of the biggest pros of parabolic SAR is its straightforwardness. The overlay is easy to read — dots above or below the price give clear buy or sell signals, making it accessible even for beginners. There’s no need to interpret complex charts or multiple data points.
- Trend identification: Parabolic SAR is particularly effective in trending markets. It helps traders stay in the trend, maximizing gains by keeping them in the trade until a reversal is signaled.
- Automatic stop and reverse: As the name suggests, the parabolic SAR automatically adjusts to market conditions, acting as a trailing stop. This feature can help protect profits by signaling when it’s time to exit a position as the trend reverses.
Limitations of the parabolic SAR
- Whipsaws in sideways markets: One of the main drawbacks of the parabolic SAR is its susceptibility to whipsaws — frequent and false signals — especially in choppy or sideways markets. The overlay may flip back and forth, leading to potential losses if trades are taken based solely on its signals.
- Oversensitivity in volatile markets: In highly volatile crypto markets, the parabolic SAR can sometimes react too quickly, giving premature signals that lead to early exits or entries. This can result in missing out on larger trends or entering trades at suboptimal points.
To mitigate some of these challenges, it’s important to learn about the parabolic SAR best practices and strategies.
Parabolic SAR trading strategies
As hinted, using the parabolic SAR on its own can be effective, but combining it with other indicators can make your signals stronger and more reliable. Let’s take a look at some of the most popular parabolic SAR trading strategies.
Trend-following strategy
- How it works: This is the most straightforward way to use the parabolic SAR. Traders follow the trend by entering a trade when the dots flip sides. For example, if the dots move from above the price to below it, it signals a potential uptrend, and traders might consider buying. Conversely, when the dots flip from below to above the price, it indicates a potential downtrend, signaling a sell.
- Ideal for: Traders who prefer riding trends and are comfortable with holding positions as long as the trend persists.
Parabolic SAR and moving average crossover
- How it works: This strategy combines parabolic SAR with a moving average to confirm trend direction. Traders might use a 50-day moving average to determine the overall trend. They then use Parabolic SAR to time their entries and exits within that trend. For instance, if the price is above the moving average and the SAR dots move below the price, it’s a strong buy signal. The reverse applies to sell signals.
- Ideal for: Traders who want an additional layer of confirmation to reduce the chances of false signals.
Parabolic SAR with RSI confirmation
- How it works: In this strategy, the parabolic SAR is paired with the relative strength index (RSI) to filter out potential false signals. When the parabolic SAR signals a trend change (dots flip sides), traders look to the RSI to confirm the momentum. For example, a buy signal from the parabolic SAR is stronger if the RSI is also rising from an oversold condition. Conversely, a sell signal is more reliable if the RSI is dropping from an overbought level.
- Ideal for: Traders who want to incorporate momentum analysis into their strategy, adding a layer of reliability to their trades.
Parabolic SAR in range-bound markets
- How it works: In sideways or range-bound markets, the parabolic SAR can give many false signals due to frequent price reversals. To counter this, traders often use the parabolic SAR in conjunction with support and resistance levels. They ignore SAR signals that occur within the range and only take trades when the price approaches key support or resistance levels, using the SAR as a trigger for entering or exiting trades at these points.
- Ideal for: Traders operating in choppy or sideways markets who want to avoid whipsaws by combining SAR with support/resistance strategies.
The parabolic SAR formula
The formula for the parabolic SAR (stop and reverse) is relatively straightforward but involves a few key components. Here’s how it’s generally calculated.
Initial calculation
When in an uptrend (dots below the price), the SAR for the next period is calculated as:
When in a downtrend (dots above the price), the SAR for the next period is calculated as:
NB.
- SAR refers to the current SAR value.
- AF is the acceleration factor. This starts at a predefined value, typically 0.02, and increases by 0.02 with each new EP in the trend, up to a maximum value, usually 0.20.
- EP is the extreme point. As discussed earlier, this is the highest high (in an uptrend) or the lowest low (in a downtrend) observed during the current trend.
Remember, if the SAR is calculated to be above the price (for an uptrend) or below the price (for a downtrend), a trend reversal is triggered, and the SAR switches sides. The SAR for the new trend starts from the most recent EP.
Did you know? The key to understanding the formulaic intricacies of the parabolic SAR is recognizing that it adjusts dynamically to the market’s behavior, accelerating as trends strengthen, which allows it to capture trend reversals effectively.
Future trends and developments in technical analysis
Traders are increasingly integrating parabolic SAR with advanced algorithms and automated trading systems, allowing for more precise entries and exits based on a blend of signals. The overlay’s adaptability to different market conditions makes it a versatile component in both manual and algorithmic trading.
However, in recent years, new overlays have emerged to challenge the parabolic SAR.
Tools like the SuperTrend overlay and the Ichimoku Cloud offer alternative methods for identifying trends and reversals. These newer tools often provide a more nuanced view by incorporating multiple factors — such as volatility and momentum — into their calculations.
Nevertheless, many traders continue to use parabolic SAR alongside these newer overlays, benefiting from its clarity and simplicity while gaining additional insights from the latest tools available.
In any case, as the crypto market matures, you can expect the further integration of machine learning and artificial intelligence, which will likely lead to more sophisticated indicators, overlays and strategies. These developments could make traditional tools like the parabolic SAR even more effective by fine-tuning their signals to better account for the unique characteristics of the crypto market.
However, you might also see the creation of entirely new forms of technical analysis, leveraging onchain data to provide insights that are currently beyond reach — potentially leading to trading techniques that could finally put the legendary parabolic SAR, at least in its current form, to rest.
Written by Bradley Peak