Introduction
This guide is designed to provide you with an in-depth understanding of the Parabolic SAR strategy and indicator itself, its mathematical construction, pro and cons and how it can be used to enhance your overall trading strategy. We include in this guide a step by step parabolic SAR Python tutorial, so you can get started on automating it too, should you wish.
The Parabolic SAR is more than just a series of dots on a chart; it’s a beacon that can guide traders through the ebbs and flows of market trends. Whether you’re a seasoned trader or just starting out, understanding the Parabolic SAR can give you a significant edge in the market.
So, let’s dive in.
What is Parabolic SAR?
The Parabolic Stop and Reverse (SAR) is a technical analysis tool that is used to determine the price direction of an asset, as well as provide potential entry and exit points. The term “Parabolic” refers to the parabolic curve shape that the indicator often forms on the chart, while “Stop and Reverse” signifies its ability to signal the point at which a current trend is likely to stop and reverse.
The Parabolic SAR is represented as a series of dots placed either above or below the price bars on a chart. In a bullish market, the dots are placed below the price bars and move upwards as the price increases. Conversely, in a bearish market, the dots are placed above the price bars and move downwards as the price decreases. The position of the dots flips whenever a trend reversal is detected, providing visual cues for traders to potentially adjust their trading strategies. You can see the chart further down this post we made from Pyton with these patterns evident.
The primary purpose of the Parabolic SAR is to help traders capture the maximum profits from major market trends. It allows traders to stay in a trend as long as it persists and signals when the trend might be changing direction. This makes the Parabolic SAR a valuable tool for identifying stop levels and trend direction, hence its popularity among traders across various financial markets.
Understanding the indicator and its applications in trading can be a game-changer for your trading strategy. It’s not just about knowing the answer to, “What is Parabolic SAR?”, but more about understanding how to use it effectively in different market conditions.
The Origins
The Parabolic SAR was developed by J. Welles Wilder Jr., a renowned mechanical engineer turned real estate developer, who later became a technical analyst. Wilder introduced the Parabolic SAR in his 1978 book, “New Concepts in Technical Trading Systems“, which also introduced other popular trading tools like the Relative Strength Index (RSI), Average True Range (ATR), and the Average Directional Index (ADX).
Wilder designed the indicator to provide a system that could capture the most profit from a trend and also signal when the trend was likely to reverse. His goal was to create something that could provide clear and objective trading signals, reducing the uncertainty and emotional factors that often affect trading decisions.
Initially used in commodities trading, its effectiveness in identifying trend reversals quickly made it popular in other markets, including stocks, forex, and cryptocurrencies. Today, it’s widely used by traders around the world, testament to Wilder’s innovative thinking and his significant contribution to technical analysis.
Understanding the Mathematics
The Parabolic SAR is calculated using a relatively straightforward formula, but it’s important to understand the components that go into it. The formula is as follows:
For an uptrend: SARn+1 = SARn + AF x (EP – SARn)
For a downtrend: SARn+1 = SARn – AF x (SARn – EP)
Where:
- SARn+1 is the SAR value for the next period.
- SARn is the SAR value for the current period.
- AF (Acceleration Factor) starts at 0.02 and increases by 0.02 each time a new high (for an uptrend) or low (for a downtrend) is reached, up to a maximum of 0.20.
- EP (Extreme Point) is the highest high for an uptrend or the lowest low for a downtrend.
| Component | Description |
|---|---|
| SARn+1 | SAR value for the next period |
| SARn | SAR value for the current period |
| AF | Acceleration Factor |
| EP | Extreme Point |
The calculation involves a series of steps that are repeated for each new period. The SAR value for the next period is calculated by adding (for an uptrend) or subtracting (for a downtrend) the product of the AF and the difference between the EP and the current SAR value from the current SAR value.
The AF and EP are dynamic values that adjust based on the price action. The AF increases each time a new high or low is reached, accelerating the rate at which the SAR converges towards the price, hence the name “Parabolic”. The EP is the highest or lowest point reached during the current trend and changes each time a new high or low is made.
The result of this calculation is a series of dots that form a parabolic curve on the price chart, providing visual cues about the direction and strength of the trend.
How to Use the Parabolic SAR in Trading
Here’s how you can make the most of this indicator:
Determining Trend Direction
The position of the dots relative to the price action can help you identify the direction of the current trend. If the dots are below the price bars, this indicates a bullish or upward trend. When the dots are above the price bars, this suggests a bearish or downward trend.
Identifying Entry and Exit Points
It can also provide potential entry and exit signals. In a bullish trend, a buy signal is generated when the dots flip from above the price bars to below them. In a bearish trend, a sell signal is given when the dots move from below the price bars to above them. These points where the dots flip can be considered as potential entry or exit points.
Setting Stop Loss Levels
The indicator is particularly useful for setting trailing stop loss levels. In an uptrend, the stop loss can be placed just below the Parabolic SAR dot, and in a downtrend, it can be placed just above the dot. As the trend continues and the dots move, the stop loss can be adjusted accordingly, helping to protect profits and limit losses.
Confirming Signals from Other Indicators
While the indicator can be powerful tool on its own, it’s often used in conjunction with other technical indicators to confirm signals and increase the probability of successful trades. For example, a buy signal from it could be confirmed by a bullish crossover in the Moving Average Convergence Divergence (MACD), increasing the confidence in the signal.
While a Parabolic SAR strategy can be put together with some simple rules, no indicator is foolproof. It’s always important to use it as part of a comprehensive trading strategy that includes risk management and considers the broader market fundamentals such as earning reports or economic or inventory figure releases.
Coding the Parabolic SAR in Python
In this section, we will guide you on how to code the indicator in Python using VSCode, fetch data from yfinance for NASDAQ index futures, and plot it on a ‘Yahoo style’ candlestick chart using mplfinance and matplotlib.
Step 1: Setting Up Your Environment
First, you need to have Python installed on your machine. If you haven’t done so, you can download it from the official Python website. VSCode has a guide to install Python and get set up within it too, if I remember correctly. Once you have Python installed, you can proceed to install the necessary libraries. Open your terminal or command prompt and type the following commands (or use the Terminal provided in VSCode if you’re already there):
pip install pandas yfinance mplfinance matplotlib
Step 2: Open VSCode and Create a New Python File
Open Visual Studio Code (VSCode) and create a new Python file. You can do this by clicking on “File” > “New File” and then save it with a .py extension.
Step 3: Import the Necessary Libraries
At the top of your Python file, import the libraries that you will be using:
import yfinance as yf
import mplfinance as mpf
import matplotlib.pyplot as plt
import pandas as pdStep 4: Fetch Data from yfinance
Next, fetch the data for NASDAQ index futures from yfinance. We will fetch the last 1 year of daily data:
data = yf.download('^IXIC', start='2022-07-01', end='2023-07-01')
Step 5: Calculate the Parabolic SAR
Now, let’s calculate the Parabolic SAR. We will define a function to do this:
def calculate_parabolic_sar(data, acceleration_factor=0.02, max_acceleration_factor=0.2):
high, low = data['High'], data['Low']
sar = (high + low) / 2
ep = high.copy()
uptrend = True
af = acceleration_factor
for i in range(1, len(data)):
if uptrend:
sar.iloc[i] = sar.iloc[i-1] + af * (ep.iloc[i-1] - sar.iloc[i-1])
if low.iloc[i] < sar.iloc[i]:
uptrend = False
sar.iloc[i] = ep.iloc[i-1]
af = acceleration_factor
ep.iloc[i] = low.iloc[i]
else:
sar.iloc[i] = sar.iloc[i-1] + af * (ep.iloc[i-1] - sar.iloc[i-1])
if high.iloc[i] > sar.iloc[i]:
uptrend = True
sar.iloc[i] = ep.iloc[i-1]
af = acceleration_factor
ep.iloc[i] = high.iloc[i]
if uptrend:
if high.iloc[i] > ep.iloc[i-1]:
ep.iloc[i] = high.iloc[i]
af = min(af + acceleration_factor, max_acceleration_factor)
else:
ep.iloc[i] = ep.iloc[i-1]
else:
if low.iloc[i] < ep.iloc[i-1]:
ep.iloc[i] = low.iloc[i]
af = min(af + acceleration_factor, max_acceleration_factor)
else:
ep.iloc[i] = ep.iloc[i-1]
return sar
Then, apply this function to our data:
data['SAR'] = calculate_parabolic_sar(data)
Step 6: Plotting the Data with mplfinance
Finally, let’s plot the data using mplfinance. We will create a ‘Yahoo style’ candlestick chart with volume bars and the Parabolic SAR overlaid:
# Create an addplot object for the Parabolic SAR
ap = mpf.make_addplot(data['SAR'], panel=0, secondary_y=False, scatter=True, markersize=3, marker='o', color='b')
# Plot the candlestick chart and the Parabolic SAR
fig, axes = mpf.plot(data, type='candle', volume=True, style='yahoo', addplot=ap, title='NASDAQ Index Futures with Parabolic SAR', ylabel='Price', returnfig=True, figratio=(10,5), figscale=1.25)
# Get the axis for the candlestick chart
ax1 = axes[0]
# Create dummy lines for the legend
line1, = ax1.plot([],[], color='b', marker='o', markersize=2, label='Parabolic SAR')
# Add a legend
ax1.legend(handles=[line1])
# Show the plot
plt.show()
This code will create a candlestick chart of the NASDAQ index futures with the Parabolic SAR overlaid as a series of blue dots. The chart includes a title, labels for the x and y axes, and a legend.
Remember to save your Python file and run it in VSCode, you can do this by pressing the play button in the top right of the VSCode screen. You should then see the same chart as mine displayed in a new window:
Pros and Cons
Understanding the strengths and weaknesses of the indicator can help you make the most of this tool when considering you Parabolic SAR strategy.
Pros
1. Easy to Interpret: One of the main advantages of the is its simplicity. The visual representation of the indicator as dots above or below the price action makes it easy to interpret, even for beginners.
2. Identifies Trend Direction: It is excellent at identifying the direction of a trend. This can help traders decide whether to enter long or short positions.
3. Provides Entry and Exit Points: The points where the dots flip can serve as potential entry and exit points, helping traders time their trades more effectively.
4. Works as a Trailing Stop: It can be used as a trailing stop, automatically adjusting to price changes. This can help protect profits and limit losses.
Cons
1. Ineffective in Sideways Markets: It tends to perform best in trending markets. In sideways or range-bound markets, it can give false signals, leading to potential losses.
2. Late Signals: While it’s obviously useful for confirming a trend, it often provides late signals. This means that by the time the indicator confirms a trend, a significant part of the trend could have already occurred.
3. Dependence on Settings: Its effectiveness can depend heavily on the settings used. The acceleration factor and maximum acceleration factor can be adjusted, but finding the right settings for a particular market or time frame can be challenging.
4. Needs Confirmation: This is usually not used as a standalone indicator. It is often used in conjunction with other technical analysis tools or combined with candlestick patterns to confirm signals and reduce the number of false signals.
| Pros | Cons |
|---|---|
| Easy to interpret | Ineffective in sideways markets |
| Identifies trend direction | Often provides late signals |
| Provides entry and exit points | Dependence on settings |
| Works as a trailing stop | Needs confirmation |
Parabolic SAR Strategy in Action: Case Studies
To truly understand its power and limitations, let’s look at some real-world examples of trades using this indicator. These case studies will illustrate how the Parabolic SAR can be used in practice and what lessons can be learned from these trades.
Case Study 1: A Successful Trade
In this example, let’s consider a bullish trend in the NASDAQ index futures. The dots are below the price bars, indicating an upward trend. As the price continues to rise, the dots follow suit, staying below the price action. When the price starts to drop, the dots flip to above the price bars, signalling a potential trend reversal. This would be the point to exit the trade, capturing the profits from the upward trend.
This example illustrates its usefulness in trending markets. It provided clear signals for the trend direction and a timely exit point.
Case Study 2: A False Signal
Now, let’s look at an example where the Parabolic SAR gave a false signal. In a sideways market, the dots flipped multiple times, suggesting several trend reversals that didn’t materialize. A trader following these signals would have entered and exited trades multiple times, likely incurring losses due to these false signals.
This case study highlights the limitations of it when applied to sideways markets. It also underscores the importance of using it in conjunction with other indicators to confirm signals and avoid false signals.
However don’t be disheartened, no indicator is infallible. What you’re really looking to do is give yourself and edge over randomness and tools like these will help you on your way to achieving that. Combined with a understanding of the market conditions in general, particularly surrounding fundamental events, you can build yourself a strong consistent edge over randomness. Just think how much casino operators make from their tiny edge. You will always have losing trades but if you consistently win more than lose and make enough to cover the associated costs of doing the trades then it’s just a matter of scaling up your strategy.
Frequently Asked Questions
In this section, we will address some common questions about the Parabolic SAR strategy. These answers aim to provide additional insights and tips for using this indicator effectively.
1. Can the Parabolic SAR be used for all types of trading?
Yes, it is a versatile indicator which can be used in various markets, including stocks, bonds, forex, commodities, and cryptocurrencies. However, it’s most effective in trending markets and may give false signals in range-bound or sideways markets.
2. What are the best settings for the Parabolic SAR?
The default settings for the Parabolic SAR are an acceleration factor of 0.02 and a maximum acceleration factor of 0.20. These settings work well in many situations, but they may need to be adjusted based on the volatility and characteristics of the specific market you’re trading.
3. Can the Parabolic SAR be used on its own?
Yes but while it provides valuable information about trend direction and potential reversal points, it’s typically used in conjunction with other technical indicators for confirmation. This can help reduce the number of false signals and increase the probability of successful trades.
4. How can I avoid false signals from the Parabolic SAR?
One way to reduce the number of false signals is to use it in trending markets, where it performs best, for example commodities are more prone to trend than other markets. Additionally, using it with other technical indicators or candle patterns can help confirm signals and increase trading accuracy.
It’s not a magic bullet but then there are no secret holy grails in technical analysis. It should be used as part of a comprehensive trading strategy that includes risk management and a thorough understanding of the markets.
Key Takeaways
If you’ve made it this far, congratulations! You’ve learned a lot about the Parabolic SAR. Here are the key takeaways from this comprehensive guide:
- It is a technical indicator developed by J. Welles Wilder Jr. to determine the price direction of an asset and provide potential entry and exit points.
- It is represented as a series of dots placed either above or below the price bars on a chart. The position of the dots flips whenever a trend reversal is detected.
- It is calculated using a specific formula that involves an acceleration factor and an extreme point. The calculation results in a parabolic curve that provides visual cues about the direction and strength of the trend.
- It can be used to determine trend direction, identify entry and exit points, set stop loss levels, and confirm signals from other indicators.
- It performs best in trending markets and can give false signals in sideways or range-bound markets.
- The Parabolic SAR Python tutorial has been included in this post. With libraries like yfinance, mplfinance, and matplotlib, you can fetch market data, calculate the indicator, and plot it on a chart.
- It has its strengths and weaknesses. While it’s easy to interpret and excellent at identifying trend direction, it can give late signals and its effectiveness can depend heavily on the settings used.
- Real-world examples of trades using a Parabolic SAR strategy as we have shown here can provide valuable insights into how this indicator works in practice and what lessons can be learned from these trades.
- It should be used as part of a comprehensive trading strategy that includes other technical indicators, risk management techniques as well as always keeping an eye on fundamentals.
Let us know how you get on with it.
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