Trading using Parabolic Stop and Reverse Indicator

[TL; DR]

🔹 Traders can combine SAR with other indicators to spot trade entry and exit points.

🔹 When the dots appear above the price it indicates a downtrend.

🔹 A reversal takes place whenever the dot moves above or below the price.

🔹 Parabolic SAR combines well with the 100 day moving average.


Introduction

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When investing in cryptocurrencies it is important to understand fundamental analysis and technical analysis as they help you make informed decisions. Indicators are an essential component of technical analysis of cryptocurrencies. As a result, most traders use a combination of leading indicators and lagging ones. The parabolic stop and lose indicator, abbreviated as SAR, is a lagging indicator that helps traders to identify trade entry and exit points.

A renowned technical analyst, J. Welles Wilder Jr, developed the parabolic stop and reverse indicator in the 1970s. In a book, 'New Concepts in Technical Trading Systems', Welles Wilder discussed the SAR also known as PSAR, the Relative Strength Index (RSI) and Average True Range (ATR). Notably, the SAR is widely used around the world as a technical analysis tool for identifying trends, reversals and breakouts.

The aim of SAR is to identify potential reversal points of a traded asset such as cryptocurrency or forex. However, Wilder recommends using SAR with other indicators to get the best results. Basically, you should use SAR to identify the trend such as uptrends or downtrends, and then use another indicator to measure the strength of the momentum.The parabolic stop and loss indicator uses a series of dots plotted above or below the current market price of the asset.


Here is an example of a parabolic stop and loss indicator.


The dots you see on the graph form the parabolic stop and loss indicator. If the dots appear above the price they indicate a downtrend. However, if they are on the bottom side of the price they indicate an uptrend. The change in the position of the dots, either below or above the price indicates potential reversal in the price movement of an asset. For example, if during an uptrend the dots shift from below the price to above it; that is an indication of the onset of a downtrend trend. And the opposite is true. If during a downtrend the dots shift from above to below the price that is a signal of the onset of an uptrend.

Therefore, a reversal point is a stage when the dot moves below or above the price. It is also important to note that the SAR works well with candlesticks, not line or bar charts. Also, it gives more accurate signals during a downtrend or an uptrend.


Calculating Parabolic SAR

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To calculate the parabolic SAR you should have three values, the prior SAR, the extreme point, and the acceleration factor. Thereafter, you use the formula to derive the SAR value. The prior SAR is the value of SAR for the previous period. The extreme point refers to the highest point of the current period during an uptrend or the lowest point of the period during a downtrend.

The acceleration factor (AF) is an established value which changes gradually if a trend continues in the same direction. Wilder established 0.02 as the initial acceleration factor. However, every time a new high occurs in the trend, the acceleration value increases by 0.02 until it reaches a maximum value of 0.20. In short, to get the SAR you use the lowest and highest prices with the acceleration factor. We use the following formulae to calculate the parabolic SAR. We use one formula during an uptrend and a different one during a downtrend.

Uptrend Parabolic SAR = Prior SAR + Prior AF (Prior EP – Prior SAR)

Downtrend Parabolic SAR = Prior SAR – Prior AF (Prior SAR – Prior EP)

After solving the applicable formula you get a value which represents the dot. However, note that you do not need to calculate the points everyday because most trading platforms have automated systems of calculating and plotting the points on graphs. What is very important is to know how to interpret the graphs.


How to use the Parabolic SAR

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One advantage of the parabolic SAR is that it is very simple to use. Generally, you buy the cryptocurrency when the dots are below the candlesticks and sell when the dots are above it.



Trend following with Parabolic SAR

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One of the strategies many traders use is trend following. Some people call this riding the trend. This strategy involves buying the cryptocurrency at the start of a trend and holding it until a reversal point. Therefore, the parabolic SAR helps you to identify the beginning of a trend as well as indicating its end. For example, if you buy a cryptocurrency at the start of an uptrend, you can hold it until the point when the dot moves below the price. Since this action signals the end of the uptrend, you sell the cryptocurrency.
However, remember that you cannot use the parabolic SAR when the market is moving sideways. This is because during that period it generates false signals.


Combining SAR with other indicators

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You can combine SAR with other indicators such as moving average to get more reliable signals. In this case, you use the SAR to confirm the trend which the moving average signals. For example, in the short trade if the 20 period moving average crosses below the 40 period moving average, you wait for the dot to appear above the price as a confirmation of a reversal trend. Once that occurs you can enter the trade. This is because that cross over indicates a high possibility of a downtrend.

You can also make use of the 100 moving average to stay within major trends rather than trading at every reversal the SAR signals. Entering and exiting the trades using only the SAR results in over trading since it signals all reversals including short term pullbacks and breakouts.

The graph illustrates an important point. The part of the graph in the rectangle shows a price consolidation where it is not profitable to enter and exit every trade following all the signals SAR gives. Therefore, the 100 day EMA gives a clear picture of the overall direction of the trend.


Conclusion

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The parabolic SAR is an essential trading indicator when trading the trend as it gives clear entry and exit points. However, SAR is effective when used with candlesticks and other indicators such as moving average. The 100 day moving average, for instance, shows the overall trend direction of the market while the SAR pinpoints the exact points to enter and exit trades. Trading using only the SAR leads to overtrading since it identifies all reversal points including pullbacks and short term breakouts during sideway markets. Therefore, SAR can act as a useful confirmation tool when used alongside the 100 day moving average.



Author: Mashell C., Gate.io Researcher
This article represents only the views of the researcher and does not constitute any investment suggestions.
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