Introducing: Parabolic SAR
The Parabolic SAR indicator is a momentum indicator. While the majority of momentum indicators are found in sub panels below our price charts, the Parabolic SAR indicator is actually plotted onto the price chart itself. Although it is indeed a momentum indicator, it’s a momentum indicator with a difference – highlighting periods where momentum is vulnerable to a reversal.
The indicator is displayed as a series of dots placed either above or below the price. The dots are used as a directional signal whereby; dots placed below price give a bullish signal indicating that momentum is expected to remain to the upside. Similarly, dots placed above price give a bearish signal indicating that momentum is expected to remain to the downside. So, in this respect the indicator can be particularly effective in helping traders identify trends.
Important to note is the fact that the indicator assumes that a trader is already in a position and the dots represent a trailing stop which is tracking price as it moves. Remember trailing stops from the “stop loss/take profit” beginner video? If not make sure to go back and check that out!
So, because of being designed in this way, the indicator is also known as the “stop and reverse” system. When the market reverses through the dots, the trend direction is classed as having reversed. Therefore, a buy entry is given when price breaks out above dots to the topside of price whilst a sell entry is given when price breaks down through dots placed below price.
In the example above you can see price is trending higher as indicated by the rising dots below price. However, In this situation, traders use the positioning of the dots as a directional guide which signals that price is going to continue higher. However, at the highlighted point you can see price breaks down below the rising dots and the dots change position, moving above price, signaling that momentum has now shifted and price can be expected to move lower. It is at this point that traders would enter a short trade as they expect the market to fall lower.
As you can see once price breaks below the dots, although market doesn’t sell off initially, after a brief period of consolidation, we do eventually see a sell-off. Typically, the way that traders will use SAR signals is to place their stop loss above the recent high for a short entry. So, putting the stop loss above the high initially allows the trade a little bit of room to breathe because the market won’t always break down straight away, sometimes it will fluctuate a bit first.
Similarly, in the image above which shows a bullish entry you can see that we enter long as price breaks above the dots and our stop loss is placed below the recent low. Using market structure for initial stop loss placement is a good way to allow the trade room to breathe initially. Reversal points can be volatile locations and as order flow is shifting, some choppiness can be expected, so using a local high or low as a stop loss location can help us stay in the trade as we give the market time to shift.
As you can see, due to the underlying momentum measurement, the indicator can be particularly effective in helping us gain entry at key market reversals. However, the Parabolic SAR indicator is not just a fantastic indicator to be used for trade entry but also for trade management.
Because the indicator highlights areas where there is the potential for a shift in momentum, the dots can be an effective location to use for trailing stop loss placement and many trend traders use the indicator to help keep them in the market longer.
Hopefully, you can see now just how useful the Parabolic SAR indicator can be in helping us identify the trend as well as in finding entry points at key reversals. The indicator gives us a simple, straightforward guide that e can use to make trading decisions on and works well on all time-frames.