When using momentum indicators, most traders focus on the RSI and stochastics indicators, which are more well known. However, along with these indicators, traders can also use the Parabolic SAR indicator which was developed by the creator of the RSI indicator; Welles Wilder. The indicator measures momentum in the market and highlights areas where momentum shows an increased chance of reversing directions.
The indicator is displayed as a series of dots placed either above or below 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. The indicator assumes that a trader is already in a position and the dots represent a trailing stop. As such, the indicator is also known as the “stop and reverse” system. Hence when the market reverses through the dots, the trend direction is classed as having reversed.
As the dots signal the likelihood of a reversal in momentum, traders can use the indicator for entries at market reversals. A buy entry is given when price breaks out above the upper dots, and a sell signal is given when price breaks down below the lower dots.
In the example above, however, you can see price is trending higher as indicated by the rising dots below price. In this situation, traders use the positioning of the dots as a directional guide which indicates continued bullishness. However at point B, 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 in anticipation of further downside.
As you can see once price breaks below the dots, although the market doesn’t sell off initially, after a brief period of consolidation, we do eventually see a sell-off. Typically the way that trader will use SAR signals is to place their stop above the recent high for a short entry and to place their stop below the recent low for a long entry.
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 is placed below the recent low. Using market structure for initial stop 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 chop and consolidation can often be expected, so using a local high or low as a stop 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 placement, and many trend traders use the indicator to help keep them in the market longer.
If we are in a short position, we can use the location of the dots above price to trail our stop knowing that if price breaks out above the dots there is the likelihood of a broader reversal occurring.
Similarly, if we are in a bullish trade, we can use dots below price to trail our stops knowing that if price breaks down below the dots there is the likelihood of a larger bearish reversal.
The Parabolic SAR indicator has a good reputation among technical analysts and traders and can be a simple yet effective way to approach the markets, helping traders to enter at key turning points and also trail stops effectively in trending markets.