A Concise Guide to the Parabolic Indicator
What is the Parabolic Indicator?
Technical analyst J. Welles Wilder Jr. developed the parabolic Stop and Reverse (SAR) indicator in the late 1970s. He first mentioned these and other popular indicators such as the Relative Strength Indicator (RSI) in his book New Concepts in Technical Trading Systems.
In fact, Wilder calls this method the “Parabolic Time/Price System” and the concept of SAR is as follows:
“SAR” stands for ‘Stop and Reverse’ and is generally the point at which long positions exit and short positions enter (and vice versa).
To this day, the system is commonly referred to as a “parabolic indicator” and is often used as a tool to identify market trends and potential reversal points. Although Wilder manually calculated many of the technical analysis (TA) indicators at the time, they are now incorporated into multi-digital trading systems and charting software. As a result, these techniques no longer require manual calculation and are relatively simple to use.
How does it work?
The Parabolic Indicator consists of a number of data points that are either above or below the market price. These points are distributed in a parabolic pattern, but each point represents a single SAR value.
In short, these points are distributed below the price in an uptrend and below the price in a downtrend. The same dots can occur during periods of consolidation when the market is moving sideways. However, in this case, the dots appear more frequently on both sides. In other words, the parabolic indicator is not useful in trendless markets.
Mileage
The Parabolic Indicator provides a reference for the direction and duration of market trends and potential reversal points. As such, it helps investors find the right time to buy and sell.
Some traders also use the parabolic indicator to determine a dynamic stop loss price, so that they can stop their losses in line with the market trend. This technique is often referred to as a trailing stop.
Essentially, the parabolic indicator allows traders to lock in their gains because if the trend reverses, they will be liquidated. In some cases, it can also prevent traders from selling profitable positions or entering trades too early.
restrict sth. within set boundaries
As mentioned above, the parabolic indicator works significantly in trending markets, but not so well during sideways trading. When there is a lack of a clear trend, this indicator can easily give false signals and cause significant losses.
Oscillating markets (up and down too fast) can also produce many misleading signals. Therefore, the parabolic indicator works best when the price is changing gradually.
Another point to note is the indicator sensitivity, which can be adjusted manually. The higher the sensitivity, the higher the chance of false signals.
In some cases, false signals can cause traders to stop their profits too early and sell when there is still room for profit. Even worse, false up signals can cause investors to be blindly optimistic and buy too soon.
As a final point, the parabolic indicator does not take volume into account enough to show trend strength in detail. While a major market change can increase the spacing between the two points, this does not indicate a very strong trend.
No matter how much information traders and investors are given, there is always risk in the financial markets. However, many people combine the parabolic indicator with other strategies or indicators as a way to minimize risk and limitations.
Wilder suggests combining the parabolic indicator with the Average Convergence Index to predict trend strength. Additionally, moving averages or the Relative Strength Index (RSI) can also be incorporated into the pre-opening analysis.
Parabolic Indicator Calculation
Today, computer programs can automate such calculations. Those interested can read this section for a brief overview of the calculation of the parabolic indicator.
SAR points are calculated based on available market data. Thus, we use yesterday’s SAR to calculate today’s value, then use today’s SAR to calculate tomorrow’s value, and so on.
In an uptrend, the SAR value is calculated based on the high of the previous period. In a downtrend, the lows of the previous period are used, and Wilder considers the highs and lows of a trend to be extreme points. However, the formulas for uptrends and downtrends are different.
Uptrend:
SAR = Previous SAR + AF x (Previous EP — Previous SAR)
Downtrend:
SAR = SAR of previous period + AF x (EP of previous period — SAR of previous period)
AF represents the acceleration factor. It starts at 0.02 and increases by 0.02 each time a new high (uptrend) or low (downtrend) is reached; however, after the 0.20 limit is reached, the value remains unchanged for the duration of the trade (until the trend reverses).
In fact, some chart analysts adjust the AF value themselves, changing the indicator’s sensitivity. An acceleration factor higher than 0.2 increases the sensitivity (more reversal signals). The opposite is true if the acceleration factor is below 0.2. However, Wilder states in the article that it works best in 0.02 increments.
Due to the relative simplicity of the calculation, some traders will ask how Wilder calculates the first SAR value, since the formula requires the value of the previous stage. According to him, the first SAR is based on the last EP value before the last market trend reversal.
Wilder advises traders to go back to the chart, look for a clear reversal point and use that EP as the first SAR value. Subsequent SAR values can be used to calculate until the next market price is reached.
For example, if the market is trending up, traders can look at the trend from days or weeks ago and find the previous correction point. Next, they would find the bottom of the correction range (EP) as the first SAR value for the subsequent uptrend.
concluding remarks
The Parabolic Indicator is a product of the 1970s but is still widely used today. Investors can use the method in many investment products, including forex, commodities, stocks and cryptocurrency markets.
However, no market analysis tool can be completely accurate. Therefore, before using the Parabolic Indicator or other strategies, investors must have a deep understanding of financial markets and technical analysis. They should participate in trading moderately and implement sound risk management strategies to mitigate unavoidable risks.
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