The Parabolic SAR indicator is a price AND time based trend-following indicator. SAR stands for “stop and reverse”. The Parabolic SAR is one of the more complex trading indicators when it comes to the underlying calculations but in this article, you will learn exactly what it is that the SAR does.
Furthermore, I encourage all traders to approach their chosen indicators with a similar approach. It is crucial to really understand what your indicators are doing, what causes them to rise or fall and how are the signals calculated. As we have seen in previous articles about the STOCHASTIC or the RSI indicator, it becomes obvious rather quickly that the majority of traders (including books, websites etc) are using those indicators incorrectly.
So let this guide inspire you on what it takes to really understand your trading tools.
Parabolic SAR Basics
The SAR rises below price as long as the price is in an uptrend. The idea behind theParabolic SAR is that it signals a trailing stop loss and during an uptrend, the SAR will only rise and never go down – always increasing the protected unrealized profits.
When the price reverses and when the price falls below the SAR (after an uptrend), then the direction changes and the SAR rises above price – acting as a trailing stop for the downtrend.
The screenshot below shows those basics effectively and during the downtrend on the left, the SAR dots were above the price, acting as a trailing stop. The candle marked when the red checkmark highlights the candle where price, for the first time, hit the SAR. When the price hits the SAR, it would lead to a stop hit, and the SAR signals a change in direction.
The Acceleration Factor -Parabolic SAR Sensitivity
How close the SAR trails behind the price is a key factor because it determines how sensitive the SAR reacts to price changes. The high the sensitivity, the faster the SAR changes its direction. This can be both good and bad, depending on the objective of the trader. If a trader prefers to get in and out of trades quickly, a high sensitivity should be chosen. A trader whose objective it is to ride trades for an extended period and remain in trades during (minor) retracements should pick a lower sensitivity.
In most charting platforms, the sensitivity is either called “step” or “increment.
Let’s compare how sensitivity impacts the SAR signals. On the left, we see the default setting of 0.2 for the increment. On the right, I set the increment to 0.4. We can see right away that the SAR on the right is giving more signals and whereas on the left the indicator seems to be smoother, the high sensitivity jumps around a lot. However, we can also see that on the most right candlestick, the price is falling rapidly and whereas the low sensitivity SAR still signals a long trade, the high sensitivity already signaled a change in direction.
Thus, the low sensitivity is good during long and strong trends, but when the direction changes quickly, a low sensitivity could lead to evaporating profits.
Difficulties trading SAR
The SAR does work well in certain conditions but, as all trend following-indicators, it fails during volatile range markets.
The screenshot below shows that the SAR changed directions 5 times during the chosen period. The SAR would have signaled 2 certain losses, 1 good sized profit, and 2 medium sized profitable trades. This might sound ok, but as we all probably can agree, rarely things go as planned and a loss quickly leads to an emotionally driven decision and things go downhill from there. It is, therefore, recommended to approach backtesting or regular chart review from a more pessimistic point of view.
This scenario shows an even worse situation and out of the 6 SAR signals, 5 would have provided losing trades and just one potential profit.
However, this does not mean that the SAR is generally bad indicator or that the signals are flawed. It just means that a trader really needs to know how to use the indicator and when to stay out of the market.
This is pretty much the premise of all trading strategies. Nothing will work 100% of the time and it’s a trader’s duty to understand when his system works and when he does not have an edge.
As with all trading indicators, tools or concepts, they should never be used on their own – generally speaking. It is always advisable to use additional filter tools to improve signal quality.
Let me provide you with a few possible solutions on how to improve the signal quality of the Parabolic SAR.
#1 ADX + Moving average
A popular combination is a moving average together with the ADX. The weakness of the SAR is range markets and that’s why this combination can improve the SAR trading signals potentially.
Here are the two filter layers:
- The ADX is your trend tiebreaker. If the ADX is above 15, you are in a trend. If the ADX is below 15, you are in a range. Thus, a trader would only look for a trade when the ADX is above 15 to avoid range markets that are so dangerous for the SAR.
- The moving average is the directional filter. When the price is above the MA, the trader only looks for potential buy trades. The SAR is his trailing stop loss and he would only re-enter long trades as long as the price is above the MA.
In the screenshot below, there is one trending phase where the ADX is above 15. During this phase, the price is above the moving average. Thus, the trader will stay aside in all other market conditions and only look for potential long entries as long as the price is in the green marked area.
#2 Slow STOCHASTIC
Remember, the goal of the filter tools is to filter out range periods. In the example below, we, thus, chose a slow STOCHASTIC setting (26,3,3). The STOCHASTIC signals strong trending markets when the lines go above 80 or below 20.
In the screenshot below you can see how precise the STOCHASTIC seems to signal trend markets. First, the STOCHASTIC confirms a long downtrend when it dips below 20 and stays there for an extended period. The SAR stop only got hit when the STOCHASTIC also rose above 20.
Afterward, the STOCHASTIC moved in and out of 80 three times. The SAR would have allowed riding the long trades as well. Between the second and the third time, the SAR stop wouldn’t have been hit so that the trader could have stayed in the trade even longer.
The goal of an indicator
When it comes to indicator trading or using any trading tool for that matter, it is important to remember a few key points.
- Indicators indicate
As the name suggests, indicators are not meant to provide signals on their own. Indicators visualize price action data on your charts. Thus, their goal is to provide information only.
- They enhance signal quality
The job of a trader to turn the indicator data into a meaningful trade idea. Amateur traders look for shortcuts and only look for crossovers or surface signals – that’s why amateurs fail because indicators can’t give signals. The professional trader uses the information the indicator provides to come up with an intelligent trade idea and uses other concepts to improve his trading.
- It’s not about a 100% winrate
When you develop an indicator based trading system, most traders make the mistake of optimizing for winrate. However, winrate is often the least important component. Instead, a trader should maximize his profitable trades and find ways to minimize losing positions. This will tilt the Reward:Risk ratio in his favor and provide much more to his positive expectancy, than just looking at winrate.