Parabolic SAR (Stop And Reverse) is a technical analysis method designed to follow currencies, stock, and securities market trends. It is an especially great system for traders involved in option and currencies trading who depend on fluctuating market trends and prefer to know beforehand when the market’s momentum might change.
Here, I have explained the parabolic SAR and how you can use it to make a profitable position.
The parabolic stop and reverse (SAR) method is a trend-following indicator that can be used to forecast potential reversal or continuation in an underlying market. By reversal, I mean a bullish market will change into a bearish one and vice versa, while continuations signify a maintained market momentum.
Traders involved in forex market or stock and options trading can use the parabolic SAR to set up a trailing stop loss and manage the timelines (entry and exit) of their market positions.
J Welles Wilder Jr., the analyst who created the relative strength index (RSI), was also the first person to use this indicator.
He made the parabolic SAR with three main goals in mind:
The parabolic SAR is calculated almost independently with the market trend assets. It emerges below the graph and converges upwards during an uptrend while emerging above the chart and converging downwards during a downtrend.
The general formula for calculating the parabolic SAR value is:
Next pSAR = Current pSAR + AF (EP – Current pSAR)
In the formula mentioned above, EP refers to the extreme point, which is a current price value record of the highest high during an uptrend or the lowest low during a market downtrend.
I’ve also used AF to denote the acceleration factor, which is initially set to a value of 0.02. This value increases by 0.02 every time a new EP is recorded but has a maximum limit of 0.20 to keep it from getting too large.
I have also derived Individual simplified formulas for calculating parabolic SAR during both market uptrends and downtrends for your ease.
During a market uptrend: Next pSAR = Current pSAR + AF (EP – Current pSAR)
During a market downtrend: Next pSAR = Current pSAR – AF (Current pSAR – EP)
The first thing you need to understand before you step into the forex or the options trading game using the parabolic SAR indicator is the meaning of the various signals it generates. On calculating the SAR, a series of dots known as a Parabolic Line is produced above or below the asset price movement lines in the market graph.
Depending on the market uptrend or downtrend, these dots can be green or red, respectively. The right time for buying or selling a currency or strategies like covered call options is when the dots are green and represented below the current asset price. Selling is usually suggested when the dots are red and positioned above the price.
A series of red dots indicate a bearish market, moreover, the first green dot is considered a sign of trend reversal. Traders often choose this time to close their short positions and establish a long position on the asset to profit from the upcoming bullish market uptrend.
On the other hand, a series of green dots suggests a bullish trend, while the first red dot is taken as a sign of market reversal. Hence, traders prefer closing down their current long positions and setting up short positions to gain returns from the predicted bearish trends in the market.
Now that you understand the basics of using parabolic SAR indicators to predict market trends, you should also consider using other methods to determine the trend strength and confirm the reversal prediction. The moving average indicator, the relative strength index (RSI), and the average directional index (ADI) can surely help you out with that.
Parabolic SAR breakout strategy
This is probably one of the easiest strategies you can apply with Parabolic SAR. The parabolic SAR can be considered a breakout indicator, as it presents you with constant breakouts. When the parabolic SAR flips to the opposite side of the price, this could be seen as a trend reversal or a breakout.
As a result, one of the most basic breakout approaches is to wait for a parabolic SAR signal to enter in the trending direction after a pullback.
If the trend is up and the price is rising overall, the Parabolic SAR flips on top of the price, signaling the start of a downturn.
Conversely, if there’s a downtrend, Parabolic SAR goes above the price to enter the pullback.
As you can see on the above chart, the price began to rise, and the red arrows indicate the beginning and finish of each trade that occurred during the uptrend. The current trade is still open, but a modest profit has already been locked in because the transaction will be closed if it falls below the indication. When the price moves above the dots in the overall uptrend, this signals a buy entry.
As mentioned above, Parabolic SAR is used to predict market trends, so you can combine it with other indicators.
Here’s how you can use the Parabolic SAR with moving average
Moving averages are one of the most utilized technical indicators among traders. Traders use multiple moving averages to confirm trends and detect reversals early. When the price is above Moving average, it indicates an uptrend; when prices drop, it indicates a downturn.
The slope of the moving average reflects the significance of a trend. Moving average crossings can also assist traders in detecting trend reversals in the market early. Because the Parabolic SAR is a lagging indicator, combining it with moving averages can assist confirm current trends and identify potential reversals early.
The below Apple chart illustrates the Moving average with the Parabolic SAR. As you can see, when the MA and Parabolic SAR made a downturn, it gave us a perfect buying opportunity. And when both indicators made an upward move, the price started to drift a bit. So here, we exit the trade.
Much similar to options trading ideas, the parabolic SAR concept is also based on the theory of time decay. Over the years, I’ve heard many traders mention that time is the enemy, and unless an asset can keep generating profits over time, it is better to liquidate it.
With that being said, the parabolic SAR indicators are not always accurate. So I advise people involved in forex, stocks, or options trading to conduct an independent analysis of the markets and consider using a trusted covered call screener and other covered call options before investing, and making backtesting before using this strategy.
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Adrian Collins works as an Outreach Manager at optionDash. optionDash is always looking forward to offering the best covered call and cash secured put screener on the internet. Adrian is passionate about spreading knowledge on stock and options trading for rising investors.
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