How to use the parabolic stop and reverse indicator

In Trading

The parabolic stop and reverse, or parabolic SAR, is a popular momentum-based indicator that can be used to pinpoint potential trend reversals in strong trending markets.

Traders also often use the parabolic SAR to determine price points for stop loss orders.

The parabolic SAR was developed by J Welles Wilder and is calculated by recent “price extremes” (EP) along with an “acceleration factor” (AF).

  • Uptrend: PSAR = Previous PSAR + Previous AF (Previous EP - Previous PSAR)
  • Downtrend: PSAR = Previous PSAR - Previous AF (Previous PSAR - Previous EP)

Using the parabolic SAR indicator

While other indicators like RSI, moving averages, and Bollinger bands are rendered as lines on a chart, the parabolic SAR indicator prints dots.

Here’s what the parabolic SAR looks like:

Using the parabolic SAR is simple:

  • The market is an uptrend when the dots are below the price.
  • The market is in a downtrend when the dots are above the price.

When the parabolic SAR dots shift from being above the price to below the price, a potential trend reversal could be starting. There are two important things to keep in mind when using the parabolic SAR indicator.

  1. Parabolic SAR is a lagging indicator, which means it follows price action. Thus, it’s a good idea to use PSAR with leading indicators like RSI.
  2. Parabolic SAR only generates usable data in a strong trending market.

With this in mind, let’s take a closer look at the ETH/USD 1-hour chart.

In the uptrend highlighted by the green arrow, parabolic SAR dots can be found beneath the price. When the trend reverses, the parabolic SAR dots move above the price.

In this particular example, we can see a high degree of confluence from two other indicators - RSI and MACD.

During the candle that parabolic SAR shifts from “under” to “over”, we can see significant weakness on the RSI indicator, as well as an imminent crossover on the MACD with a histogram reset.

Here’s an example of how PSAR can be extremely misleading in ranging or consolidating markets. On this XRP/USD 15-minute chart, we can see two sets of parabolic SAR dots highlighted by arrows.

The parabolic SAR dots above price (red arrow) indicate that that market should be downtrending, but that’s not really the case at all.

In fact, during this supposed downtrending period, XRP actually made higher lows. Similarly, the green arrow highlights a period of time where the market should be uptrending based on the parabolic SAR dots.

Once again, this is not the case because XRP was not in a strong trend.

Conclusion

The parabolic stop and reverse indicator is a powerful tool that can be used to find profitable entry and exit signals in strong trending markets.

Remember to never use parabolic SAR in a sideways or consolidating market because it will generate a lot of false signals.

And finally, since parabolic SAR is a lagging indicator, it’s always best to use it with a leading indicator like RSI or stochastic oscillator along with candlestick analysis.

This content is not financial advice and should not form the basis of any financial investment decisions nor be seen as a recommendation to buy or sell any good or product. Trading cryptocurrency is complex and comes with a high risk of losing money, particularly if you trade on leverage. You should carefully consider whether trading cryptocurrencies is right for you and take the time to learn how trading works and decide how much money you are prepared to lose.

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