Parabolic Stop and Reverse (Parabolic SAR) Indicator for beginners

 In the world of technical analysis identifying trend direction and spotting trend reversals are crucial for making smart trading decisions. While identifying trend direction helps you to position yourself in parallel with overall market sentiments, spotting a trend reversal enables you to take position early and make more profits. Parabolic Stop and Reverse (Parabolic SAR) indicator does exactly that.

Parabolic SAR allows us to peek into the trend direction and also indicates when it reverses and that too in a straightforward and effective manner.

Let's dive deeper into this indicator.

What is a Parabolic SAR indicator?

J. Welles Wilder, the man who formulated indicators like RSI and ADX, conceived the idea of Parabolic SAR as well. A Parabolic SAR is a trend indicator that reveals the trend direction as well as trend reversals through a series of dots plotted above or below the price.

Parabolic SAR indicator thus enables you to see the direction of trend and trend reversals in visually straightforward way. This simplicity has made this indicator popular among scores of traders all over the world.

Let's see this in a chart.

The chart above is a daily chart of NIFTY with Parabolic SAR indicator. Notice that the indicator has been shown as series of dots above or below the price (candlesticks).

Don't be perplexed by these dots yet as in the paragraph that follows I will unravel the way these dots are interpreted.

How to interpret Parabolic SAR indicator-

Parabolic SAR stands out because of its simplicity and thus interpreting this indicator is not that difficult. By visualizing the position of dots in relation to corresponding price you can peek into the direction of the trend of any stock as described below.

1. Dots below price- The stock is in uptrend
2. Dots above price- The stock is in downtrend
3. Dots crossing below price from above- The stock was in downtrend but now has reversed to an uptrend, that is, a bullish reversal has occurred.
4. Dots crossing above price from below- The stock was in uptrend but now has reversed to a downtrend, that is, a bearish reversal has occurred.

Observe this in a chart shown below.

Now that you have a basic idea about the interpretation of Parabolic SAR indicator, let's now move on to next part- How to use Parabolic SAR indicator?

How to use Parabolic SAR indicator?

Traders use Parabolic SAR to make three main trading decisions-

To identify trend direction- 

As already stated Parabolic SAR gives a straightforward visual to show the trend direction. Dots below the price mean stock is in uptrend and traders who are already long should continue with their position. Similarly, dots above price suggests a downtrend and traders who already have short position should hold their positions.

To Spot Entry and Exit points-

For me Parabolic SAR is one of the indicators that I use for swing trading to make entry and exit decisions. 

Parabolic SAR can be used to find entry and exit points. Dot crossing below price from above is a buy signal while dot crossing above price from below is considered a sell signal. This has been shown in a chart below.

The chart above shows potential entry and exit signals generated by Parabolic SAR.

A word of caution here, though these entries and exits look very straightforward but Parabolic SAR must not be used alone to make trading decisions as the indicator can give many false signals ,specially in sideways market. 

But once paired up with other indicators Parabolic SAR aids in making profitable trading decisions. The indicators to be used along with Parabolic SAR will be discussed in a separate section later in this article.

To set stop-loss-

Stock movements are never guaranteed even with the best indicator combination. This is why setting stop-loss is so important. It helps limit your potential losses, protects your capital and aids in removing emotional decision making.

Parabolic SAR can help you in placing a proper trailing stop-loss which adjusts dynamically as the trade progresses.

For example, in a long setting the dots appear below the price and as the price moves up these SAR dots also move up. You can place your stop-loss just below these dots and as the dots move up you should also move your stop-loss up following the dots.

Best indicators to use with Parabolic SAR-

Though Parabolic SAR is a pretty simple indicator that gives explicit buy and sell signals, however, the indicator is not infallible. The indicator produces many false signals, specially when a stock is trading in a range.

This is why you should always pair up Parabolic SAR with other indicators to authenticate the buy and sell signals. So, what are these indicators that complement Parabolic SAR?

Parabolic SAR is a trend following indicator, so it works well with stocks which are trending and does poorly when a stock is rangebound.

Thus, the best indicators to use with Parabolic SAR are the one which assist us in glancing the trend and trend strength, like Moving Averages and Average Directional Index (ADX).

J.Welles Wilder, the person who discovered Parabolic SAR, proposed to use this indicator in conjunction with ADX. ADX along with directional movement indicator tells you about direction and strength . Thus when you take signals in direction of trend and when ADX is above 25 the chances of a winning trade is increased.

See this in a chart below.

Similarly you can also use Moving Average with Parabolic SAR to get better entries. For example, you can go for a buy when price is above SMA50 and SMA50 is inclined upwards and Parabolic SAR dot crosses below price from above.

Price above SMA50 which is inclined upwards suggests the trend is upward and thus a buy entry is made when Parabolic SAR goes below price. See this in a chart below.

Apart from ADX and Moving average other indicators that complement Parabolic SAR are Moving Average Convergence Divergence (MACD) and Relative Strength Index (RSI).

Conclusion-

While Parabolic SAR is simple yet powerful indicator that shows the trend direction and potential reversals, it should not be used alone. Its real power is unlocked when it is complemented with other indicators like, ADX and Moving Average. By combining Parabolic SAR with tools that confirm trend strength and direction, traders can filter out noise and make more confident, informed decisions.

Apart from giving clear cut trade entries, you can also use Parabolic SAR to place dynamic trailing stop-losses, thus allowing you to protect profits as the trade evolves.