Parabolic SAR (Stop and Reverse)
Parabolic SAR also known as PSAR, is a technical analysis indicator widely used to identify the direction of a security's price movement and its potential reversal points. It is a popular indicator in the trading community and is easy to use. The PSAR was developed by J. Welles Wilder Jr and introduced in his book ‘New Concepts in Technical Trading Systems’ in 1978.
The PSAR is plotted on a price chart and appears as a series of dots above or below the price bars. The dots above the price bars indicate a downward trend, whereas the dots below the price bars indicate an upward trend. The PSAR moves below the price during an uptrend and above the price during a downtrend. The dots from PSAR act as stop-loss orders when the dots are crossed by the price. Hence it is called a 'stop and reverse' system.
When the trend of the price is up, the dots of the PSAR are below the price. Every day the dots move closer to the price. When the price touches the dots, the indication is that the trend may have reached exhaustion and that the price may start trending downwards. Conversely, when the trend of the price is downwards, the dots of the PSAR are above the price, and when the price reaches the dots, it suggests that the price may reverse its direction and begin to rise.
The calculation for PSAR is very complicated to do on a paper but it is easy to understand. The PSAR calculation formula is based on the following variables:
- EP (Extreme Point): EP is the highest or lowest price of the current trend depending on whether the trend is up or down.
- AF (Acceleration Factor): The AF indicates the rate at which the PSAR dots will move. The rate increases as the trend continues.
- PSAR (Current Price): The PSAR is the value at which the dots are plotted above or below the price bars.
The PSAR formula is as follows:
PSAR = PSAR (previous) + AF x (EP - PSAR (previous))
The above formula indicates that the AF and the EP determine the PSAR for the next period which is plotted on the chart. The AF starts at 0.02 but increases by 0.02 each time the EP reaches a new high or low, until it reaches a maximum of 0.20.
The PSAR indicator is best used in a trending market. We should avoid using it in the ranging market or choppy market conditions, where it may generate false signals.
Limitations of PSAR Indicator
Like any other technical indicator, the PSAR has some limitations that traders should be aware of before using it to make trading decisions. The following are some of the limitations:
- PSAR can be a lagging indicator, which means that it may lag behind the actual price movement.
- The signal generated by PSAR can be choppy and whipsawed in ranging markets, which may result in many false signals.
- PSAR is most effective when used in conjunction with other indicators to confirm the trend direction.
- PSAR is not a standalone tool, and it should not be used to make trading decisions on its own. It should be used as part of a comprehensive trading strategy that incorporates other technical indicators, fundamental analysis, and risk management techniques.
Conclusion
The PSAR is a popular indicator in technical analysis that can help traders identify the trend direction and potential reversal points. It is easy to use and interpret, but it does have some limitations that traders should be aware of. It is always recommended to use PSAR in conjunction with other technical indicators, fundamental analysis, and risk management techniques to develop a comprehensive trading strategy.