Trading is founded on the fluctuating prices of various trading commodities. In any market, the price action tends to vary over time as it shifts upward then rescinds this position at a later date.
This movement enables traders to capitalize on an option’s diminished value when they buy into the market. Further on, as the value rises, these items are offloaded, and the difference is what traders pocket as a profit.
Now no one really knows how to predict the future. Traders are similarly disadvantaged when it comes to forecasting. Nevertheless, there are financial tools that aid traders when it comes to making decisions concerning future price action in the market. Traders employ these tools often in their trading strategies.
The parabolic SAR is one such tool and is currently enjoying massive popularity among traders today. Coupled with moving averages, the SAR continues to enable traders to latch on to bullish and bearish signals thereby aiding their trading ventures.
What is parabolic Stop And Reverse (SAR)
The SAR indicator is a favorite among technical traders who are keen on price action. It allows traders to monitor price movements as well as deviating trends as they seek out reversals in the market.
Traders regularly address market trends pointing out their significance in trading. Typically, the prevailing price direction should help you figure out where the price of a commodity is heading. The price action determines patterns. When a reversal is about to take place, the price curve usually reacts to emulate the shifting pattern.
The SAR indicator was developed by renowned trading authority J. Welles Wilder responsible for other indicators like RSI. Initially referred to as the stop and reverse system, SAR is mainly intended to pick out likely reversals in price action.
On a price chart, the SAR indicator is seen as a series of dots that run alongside the price. The SAR’s position relative to the price is then used to deduce trading signals. To work effectively, traders typically apply the parabolic SAR in markets that exhibit a strong trend hence a favorite among trend traders.
How does the parabolic SAR work?
SAR is used to point out whether the market will move in a bearish or bullish direction depending on where it lies with respect to the price line. As a rule of thumb, when the dots pass above the price, you can expect a downward trend. This can then indicate that the market is ripe for selling.
The opposite holds when the dots appear just below the price. The price action is improving, and buying into the market would be an ideal decision to make.
As the price appreciates, the SAR series of dots move in tandem with it. Once the trend gathers steam and strengthens, so does SAR. Eventually, the dots ride through the price to emerge on the other side. During this time, you will encounter signals which, depending on the dots’ position, indicate whether to buy or sell
Since SAR is dependent on trending markets, it can be ineffective if a market is smooth sailing. When markets express heightened volatility, it is usually harder to point out the trend, and the SAR will not be of much use then.
Indicators used alongside parabolic SAR
The SAR indicator, as pointed by Wilder, shouldn’t be used solely to determine your trades. Varying levels of volatility characterize trading. This feature tends to distort the prevailing trend and makes the parabolic SAR inaccurate.
To be able to smoothen out the effect of volatile markets, make sure you have other indicators working in conjunction with SAR. Some of these useful indicators you should include in your strategy are highlighted below:
· RSI
Wilder also developed the RSI which works well when paired with the SAR. RSI indicates the momentum of price action. How fast the price of an asset appreciates or depreciates points out its strength given the direction it follows.
While trading, upward and downward trends occur concurrently and at times, these movements may not indicate a proper pattern in the market. However, the RSI should be used to convince you whether a shift in the price bears any hope of prevailing. This way, you will be able to gauge the general market behavior and, alongside SAR, give solid buy or sell signals.
· Moving average
The moving average indicator shows the average price of an asset when the market closes. It is applicable over a pre-determined period and is an excellent pointer when determining market momentum.
· MACD
MACD connects two moving averages for a pair of asset prices. It showcases fluctuating price momentum between the pair. The averages often move independently, often converging, diverging and overlapping.
MACD uses a histogram to showcase either bearish or bullish indications. A positive value on the histogram is normally taken to mean a diminishing upward trend.
· Average Directional Index (ADX)
Also developed by Welles Wilder, ADX works in tandem with both plus and minus Directional Indicators alias, DMI- and DMI+. The indicator measures momentum and is a useful tool when determining the strength of a trend.
ADX was initially meant for the commodities market since Wilder was also party to commodity trading. However, the indicator today cuts across various other markets like forex, stocks and ETFs.
· Candlestick patterns
Candlesticks have been in use for centuries and are useful when predicting price direction. They are colorful vertical bars that are a great addition to your trading chart.
Candlesticks condense data from several timeframes into individual price bars. As opposed to traditional lines that use closing prices, candlesticks provide valuable information considering the wealth of information used to generate them.
Using the parabolic SAR indicator
In trending markets, it is fairly easy to predict price movements and decide when to trade. However, once you have determined a perfect entry point, you should then consider the exit strategy. The SAR can be used to point out when the market is about to reverse. At this point, you should sell and capitalize on the asset’s maximum value.
The parabolic SAR mainly uses dots that appear on a price chart. The position of these dots is then used to indicate bearish or bullish signals.
Besides trend trading, the parabolic SAR is also applicable in other ways as underlined below:
1. As a stop-loss
One of the most widespread uses of parabolic is as a stop-loss. While trading, price drops tend to diminish your revenue, so you need to protect your position and your profits. Dealing with a trailing stop-loss works towards achieving this.
The parabolic SAR indicator is an actively shifting indicator. Most of the time, it is continually giving off trading signals. Set your trailing stop loss to match the indicator while the stock or asset price rises. This is a powerful indicator more so for day traders who wish to skip the traditional stop loss.
When shorting, the price decline is prominent, and including a parabolic SAR in your strategy helps protect your profits. The SAR decreases with downtrends and vice versa for upward moving trends. As SAR lies above the price, it eventually falls following the declining price.
2. Detect your trading exit points
The parabolic SAR is a valuable tool that helps you determine whether to exit a trade or not. Your entry and exit strategies greatly define your profitability.
You need to enter the market when the price allows you to get the best value for money. On the other hand, a good exit strategy will enable you to cash in on a good uptrend.
You need to have optimum points for both exit and entry and hence the need to consider a parabolic SAR. Furthermore, what use is an excellent entry strategy when your exit point does not guarantee your projected returns.
3. Works as a swing trading tool
The parabolic SAR indicator excels in markets with strong trends. As such, it is a reliable indicator when swing trading. When swing trading, you buy into the market then hold out for several days at a time. This gives you enough time to observe the prevailing trend and identify exit points on the price action.
Limitations of SAR indicator
One inhibiting factor in SAR is its dependence on trending markets. Once prices begin to move sideways, the indicator produces a lot of fake signals.
As there is no trend to follow, the parabolic SAR will simply follow the price around. As a trader, the signals will be present on your chart. However, these aren’t dependable indications of whether you can sell or not.
Traders mitigate this shortcoming by combining SAR with other indicators. Doing so clears out the noise and gives you reliable signals. Additionally, if you want to use the parabolic SAR, only consider it for trending markets.
Finally, it is essential to remember that the SAR indicator is always giving signals along the price line. It is up to the trader to determine the dominant trend direction and capitalize on it. To have a surefire trading strategy with SAR, make sure you have included other indicators such as moving averages to help to weed out weak trading signals.