INFO: Introduction to the Parabolic SAR
April 22, 2002 | By Investopedia Staff, (Investopedia.com) The 'parabolic SAR' is an indicator that we can safely say is a very useful and accurate tool during a trending period, but is otherwise absolutely useless.
This time/price system was first introduced by J.Welles Wilder in his acclaimed book "New Concepts in Technical Trading Systems" (1978). SAR stands for 'stop and reverse' and the term 'parabolic' comes from the shape of the curve (resembling a parabola) created on the technical chart.
Sometimes called a reversal system, the Parabolic SAR allows the investor to follow the dots in either an upward or downward trend until SAR is reached and the trend reverses. It is primarily used in trending markets and is based on always having a position in the market. The indicator may also be used to determine stop points and to estimate when to reverse a position and take a trade in the opposite direction.
The first entry point on the buy side occurs when the most recent high price of an issue has been broken and it is at this time that the SAR is placed at the most recent low price. As the price of the stock rises, the dots will rise as well, first slowly and then picking up speed and accelerating with the trend. It is understood that Wilder built-in this accelerating system to allow the investor to watch the trend develop and establish itself. The SAR starts to move a little faster as the trend develops and the dots soon catch up to the price action of the issue you are following. As you can see in the charts below, the system, as I have mentioned before, works extremely well in markets with a dominant trend markets and fails miserably in horizontal or choppy markets.
Now, given that sectors and the stock issues in those sectors will never trend immediately from any position on a chart, they will eventually develop. The accelerating system is extremely valuable because it allows for the investor to get into the issue after they see the dots move closer to the price action, thus confirming that the trend is established. One of the tricks of the trade is the use of stop-loss orders using the development of the SAR to lock-in profits that have been realized on paper in an upward trend. You can also see that those professionals that short the market will use this system to help determine the time to cover their short positions.
This trading system is extremely mechanical, and therefore takes out all of the human emotion that can get many new investors as well as the occasional veteran in big trouble. "Never fall in love with a stock, because it will never love you back." With Parabolic SAR, all the emotion is taken out of the equation. The investor becomes disciplined and a more consistent trading pattern is achieved. The downside to this system is that most stocks that we follow do not develop consistent trends and therefore create a herky-jerky SAR that is somewhat predominant in our charts, which makes it difficult to enter and exit with consistent profits.
In this chart of Nortel Networks from the first few months of 2002, the trader can see no real indication to get on the buy side of this issue, as a strong downtrend continues with brief false starts created by positive comments from fundamental analysts, the ensuing short covering and knee-jerk reactions from cheap stock gamblers.
I have thrown in a 50-day moving average to reinforce the thought that this issue still has a strong downtrend that was created 19 months and still prevails today.
Have a look at the arrows I have inserted on the EBAY chart to point out the trend patterns developed over the last year or so, and how an investor could have profited substantially by simply following the dots during the period from Oct 2 to Dec 7, 2001. I would also suggest studying the chart to see the downside to this system in its timing of a trend reversal. If an investor were to use a tighter stop-loss system than this indicator, he or she would not end up losing the kind of money that this chart shows in its slow timing frame.
In summary, the parabolic SAR is a fairly good tool if the issues or sectors on your radar screen are trending. But if they are not, you could get very frustrated using this indicator alone. http://www.investopedia.com/articles/technical/02/042202.asp