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Parabolic Stop and Reverse (SAR)

The Parabolic SAR is an indicator used to identify trends.  A lot of traders use this indicator to enter trades but I have found through my experience that it can also be used to set stop orders.  

This indicator is somewhat a lagging indicator by this we mean that when price hits SAR some of the move has already occurred.  However the indicator works well in strongly trending markets and it is very good at identifying new trends.  However it is a lagging indicator so it does not work well in flat markets since some of the move has already happened when the indicator triggers. Therefore in a flat market not much of a move is left in the stock when the indicator triggers.  But in trending markets this will not matter because even if you miss a little of the move there should be enough of a move left in the stock if the stock is trending for you to make a considerable profit in the balance of the stocks move. 

The SAR works best for establishing the trend first then the Parabolic SAR is used to trade in the direction of the trend.  The indicator is very simple to use.  If the trend is up we buy when the indicator moves below the price. If the trend is down we sell when the indicator moves above the price. The dotted lines below the price will establish our trailing stop for a long position.  The lines above the price will establish our trailing stop for a short position.  In the chart of LBIX tonight we will have an example of how to use the SAR to set a stop order. LBIX is probably not the best example because it is a volatile stock but you can test it yourself using other stocks that are less volatile and trending slowly up or down.  

At the beginning of a stocks new trend the Parabolic SAR will provide a greater cushion between the price and the trailing stop. As the move gets underway the distance between the price and the SAR will close in making for a tighter stop order as the price moves in a favorable direction.  The indicator does the work for us; it will adjust our stop so we can lock in profit as the stock moves in the direction of our trade.  This indicator takes all the emotion out of deciding where to place the stop. 

The Parabolic SAR can catch most trends and allow us to profit from the buy/sell signals it gives at the start of a new trend.  Keep in mind that the validity of the indicator is only as good as the market or stock.  If you try and use the SAR in a flat trendless market it becomes ineffective and you will be subject to false signals resulting in whipsaw trades. 

For our purposes tonight we will talk about how to use the SAR in relation to setting stop loss orders to protect profits and limit losses. The SAR will provide us stoploss levels for both sides of the market moving incrementally each day with changes in the price of the stock we are trading.  The SAR is plotted on the chart and will occasionally intersect with price due to a reversal or loss of momentum in a stock.  If we set our stop order at SAR when this intersection occurs we will be stopped out of our trade. We can then reverse our position immediately and take the other side of the trade. 

For example if our long position is stopped out we can now sell short by entering a new trade and setting a trailing stop immediately above SAR.  Remember in our long position our stop was placed below SAR.  When price fell below SAR we were stopped out and we now take the short side of the trade because price is now below SAR indicating a reversal of trend so we want our stop above SAR when we are short. 

Using SAR we can capture the movement of the stock in both directions taking maximum advantage of the stocks movement in either direction as the stock fluctuates up and down over time. The key is time when using SAR we want slow steady trends with very little volatility over longer periods of time. 

The disadvantage of SAR is that it is not only worthless in a flat market but it is also not reliable in a fast moving very volatile stocks or markets that swing wildly from day to day.  In these cases if the stock moves up and down too quickly our stop will be triggered too early.  In other words it does not work well in a choppy market either. 

The Bottom Line
The SAR is a fantastic indicator for identifying new trends in a trending market and can be used to enter new trades as well as to set stop price exits.  But the SAR is useless in a flat/trendless market or in markets that move sporadically up and down.  SAR is not to be used in choppy markets or with volatile stocks.

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