When trading stocks, it's important to have a way to predict trends in advance or at least to confirm them in their early stages. While “lagging” or “trend-following” indicators can sometimes be useful to confirm a trend that's already started, they often kick in when it is too late to take advantage of them.
So it's better to know where the price is headed ahead of time. This is why parabolic SAR is one of the most useful indicators in a trader's toolset.
But there's a lot of misinformation about this indicator. So in this article, I'm going to give an explanation of the correct way to use parabolic SAR for stock trading.
Parabolic SAR was developed by Welles Wilder in his book, New Concepts in Technical Trading Systems.
It's based on a complex algorithm that uses the highest point of the current uptrend and an “acceleration factor” that increases as the uptrend makes new highs. Parabolic SAR is basically a measurement of the momentum of a stock's price. This is important...because momentum often changes right before the price does.
As a result, this indicator can often be used to predict changes in trend in their very early stages or even before they happen at all.
Parabolic SAR creates a series of dots on the chart either above or below the price. If the dots are above the price, it means the stock is in a downtrend. If the dots are below the price, it means the stock is in an uptrend.
A lot of analysts say that the way to trade stocks using parabolic SAR is to simply buy when the dots move from above the price to below it or sell when the dots move from below the price to above it.
While this can work, there are some problems with it...as the Netflix (NFLX) chart below shows.
In December, 2016 and January, 2017, a simple “buy when dots are above and sell when dots are below” strategy would have worked out. But beginning in late February, 2017, it would have caused you to be “whipsawed” or stopped out multiple times. This would have been very frustrating.
So how do you get around this?
Here's how to get around the “whipsawing” problem in three steps:
1. Look for a candlestick reversal pattern (railroad tracks, engulfing, hammer, inverted hammer, three white soldiers, etc.)
2. When you see a reversal pattern, wait for parabolic SAR to confirm that the trend has changed.
3. When the reversal pattern is confirmed by parabolic SAR, enter the trade with a stop-loss placed on the dot created by it.
4. Trail your stop to the next dot as the trend continues.
Now let's look at the chart to see how this would have played out if this strategy was used instead.
In early January, the chart showed a “three white soldiers” pattern with three very strong moves up. If a stop had been placed on the fourth dot crated by parabolic SAR, it would have been very far from the price. But as the price continued upward, the dots moved closer to the price. This is because momentum was slowing.
If the stop had been trailed as the dots moved upward, the trade would not have been stopped out until the middle of February after many gains had been made.
The next time parabolic SAR produced an uptrend signal, there was a candlestick pattern that could be interpreted as “three white soldiers” again. However, the third candle was smaller than the first two. So it would have been easy to see that this was not a true signal. So hopefully you would not have entered the trade and gotten whipsawed.
Of course, even this method of using parabolic SAR isn't foolproof. But it will often allow you to turn profits over the long-run.Parabolic SAR is a useful indicator to detect trends in advance or in their early stages, as long as you