Our Trading 101 series covers the essential tools and indicators that you can use to understand how basic market trading works, allowing you to make money in the crypto markets and beyond. This week we look at the parabolic stop and reverse (SAR) indicator, its uses and limitations.
About the Parabolic SAR
The parabolic SAR is mainly used by traders to determine the future short-term momentum of an asset. The indicator was developed by J. Welles Wilder Jr., creator of the Relative Strength Index (RSI), and is used to help traders place stop orders. The parabolic SAR indicator is represented on a chart as a series of dots placed either above or below the price, depending on the asset’s momentum. When the trend of the asset is upward you will see a small dot below the price followed by a stream of dots to illustrate the trend, with a dot placed above the price and a downward stream when the trend is down. A reversal of the dots from one side to the other indicates a potential change in direction, which many traders use as a buying/longing or selling /shorting signal.
Parabolic SAR Use
The parabolic SAR performs best in markets that have a steady trend, like foreign exchange. In ranging markets like Bitcoin, the parabolic SAR tends to leap back and forth, potentially generating false trading signals, although it still works when BTC is in a general trend. As we have said many times in this series, no indicator should be used in isolation, and some traders like to use candlestick patterns or moving averages alongside parabolic SAR to determine their trading activities. For example, seeing a price fall below a major moving average can be seen as a separate confirmation of a sell/short signal given by the parabolic SAR.
Limitations of Parabolic SAR
Parabolic SAR can often lead to entering or exiting a position prematurely if it is used in isolation. This happens when traders choose to place their trailing stop loss orders at the parabolic SAR value, feeling that a move beyond this would signal a reversal, which causes them to anticipate a move in the opposite direction. However, when in a sustained trend, the parabolic SAR is usually far enough removed from price to ensure that a trader doesn’t get stopped out of a position during the kind of temporary retracements that happen during a long-term trend.
Parabolic SAR can be a good indicator of when a market is turning, although of course it should not be used in isolation and should be used with caution in a heavily volatile market where a trend is not evident. Make sure to check back next week when we look at the Average Directional Index (ADX).