What is the Parabolic Indicator?

Technical analyst J. Welles Wilder Jr. developed the Parabolic Stop and Reversal (SA strong>R) indicator. He first mentioned the above indicators and other popular indicators such as the Relative Strength Index (RSI) in his book "New Concepts in Technical Trading Systems".

In fact, Wilder calls this method a "parabolic time/price system" and the concept of SAR is as follows:

"SAR" stands for "stop and reverse" and is generally the point at which longs exit and shorts enter (and vice versa).

- Wilder, J. W., Jr. (1978).New Concepts in Technical Trading Systems (p. 8).

To this day, this system is commonly known as the "parabolic indicator" and is often used as a tool to identify market trends and potential reversal points. While Wilder manually calculated many of his technical analysis (TA) indicators at the time, they are now integrated into many digital trading systems and charting software. As a result, these technologies no longer require manual calculations and are relatively simple to use.

How does it work?

The Parabolic indicator consists of data points that are above or below the market price. The distribution of these points is parabolic, but each point represents a single SAR value.

In short, these points are distributed below the price in an uptrend and below the price in a downtrend. During the consolidation period when the market moves sideways, points will also appear. However, in this case, small dots appear more frequently on both sides. In other words, the parabolic indicator has no place in a trendless market.

Benefits

The parabolic indicator can indicate the direction of the market trend and Duration and potential reversal points provide a reference. Therefore, it helps investors find the right time to buy or sell.

Some traders also use the parabolic indicator to determine dynamic stop prices and therefore stop losses in line with the market trend. This type of technique is often called a "trailing stop."

Essentially, the Parabolic Indicator allows traders to lock in profits because they will be liquidated once the trend reverses. In some cases, it can also prevent traders from selling out of profitable positions or entering trades prematurely.

Limitations

As mentioned above, the Parabolic Indicator works well in trending markets It has a significant effect in mid-term, but it is not very effective during sideways trading. When there is no clear trend, this indicator can easily give false signals, causing heavy losses.

A volatile market (rising or falling too quickly) can also produce many misleading signals. Therefore, the Parabolic indicator works best when the price is changing gradually.

Another point to note is the indicator sensitivity, which can be adjusted manually. The higher the sensitivity, the higher the chance of false signals.

Sometimes, wrong signals can cause traders to take profits prematurely and sell when there is still room for profit. Worse, false rising signals can make investors blindly optimistic and buy prematurely.

Last point, the Parabolic indicator does not fully consider trading volume and cannot show the trend strength in detail. Although major market changes can increase the distance between two points, this does not necessarily mean that the trend is very strong.

No matter how much information traders and investors obtain, there are always risks in financial markets. However, many people combine the Parabolic Indicator with other strategies or indicators as a way to minimize risks and limitations.

Wilder recommends combining the Parabolic Indicator with the Average Trend Index to estimate trend strength. In addition, moving averages or relative strength index (RSI) indicators can also be included in the analysis before opening a position.

Parabolic indicator calculation

Nowadays, computer programs can do it automatically Such operations. Interested people can read this section to briefly understand the calculation of the parabolic indicator.

SAR points are calculated based on available market data. So we use yesterday's SAR to calculate today's value, then use today's SAR to calculate tomorrow's value, and so on.

In an uptrend, the SAR value is calculated based on the high point of the previous period. A downtrend uses the previous low. Wilder considers the highest and lowest points in a trend to be extreme points. However, the formula for an uptrend is different from that for a downtrend.

Uptrend:

SAR = SAR of the previous period + AF x (of the previous period EP – SAR in the previous stage)

Downtrend:

SAR = SAR of the previous stage + AF x (EP of the previous stage – SAR of the previous stage)

AF represents the acceleration factor. It starts at 0.02 and increases by 0.02 each time it reaches a new high (uptrend) or new low (downtrend). However, after reaching the 0.20 limit, the value remains unchanged during the trading period (until the trend reverses).

In fact, some chart analysts will adjust the AF value themselves to change the sensitivity of the indicator. Speedup factors higher than 0.2 increase sensitivity (more inverted signals). If the acceleration factor is below 0.2, the opposite is true. However, Wilder stated in the article that increments of 0.02 have the best effect.

Since the calculation is relatively simple, some traders will ask how Wilder calculates the first SAR value, since this formula requires the value of the previous stage. According to him, the first SAR is based on the last EP value before the last market trend reversal.

Wilder recommends traders go back to the chart, look for a clear reversal point and use that EP as the first SAR value. Subsequent SAR values can be used in calculations until the next market price is hit.  

For example, if the market is trending upward, traders can look at the trend days or weeks ago to find the previous correction point. Next, they will find the bottom of the correction range (EP) as the first SAR value for the subsequent uptrend.

Conclusion

Although the parabolic indicator was developed in the 1970s product, but is still widely used today. Investors can use this method across many investment products, including foreign exchange, commodities, stocks and cryptocurrency markets.

However, no market analysis tool can be completely accurate. Therefore, before using the Parabolic Indicator or other strategies, investors must have a deep understanding of financial markets and technical analysis. They should participate in transactions appropriately and implement reasonable risk management strategies to mitigate unavoidable risks.