It seems I am always writing about Welles Wilder and his 1978 classic, New Concepts in Technical Trading Systems, and this article will highlight one of his most interesting indicators from the book for use in trending markets. There will be those who argue that the Parabolic SAR has other uses, but I have found it less than effective in non-trending markets and a champ in trending markets. Traders who carve out small chunks of profit and then quickly exit are called scalpers, and I am a scalper. For a scalper like me avoiding the inevitable retracement in a trend is essential and difficult to predict.
The Parabolic SAR is usually depicted on a trading chart by a series of dots moving in relation to the asset price activity on the chart. To the best of my knowledge, it is the only indicator that is generally represented in this manner. In a nutshell, when the dot series of the Parabolic SAR (incidentally the SAR stands for "stop and reverse") is below the price action, this is considered a bullish signal. As you might guess, when the pattern is riding above the price action this is considered a bearish signal. If nothing else, the Parabolic SAR keeps a trader well aware of the prevailing momentum in the market. And many people use the indicator to enter trades, both short and long. While the system works well enough, it is my belief that there are better indicators for this purpose.
Drops, or breakdowns in the market generally occur at a pace three times quicker than upward movement, or breakouts. Breakdowns tend to be very violent and frenetic events, while most breakouts or up trends tend to be more gradual and calculated. This means that a move to the upside is typified by a period of rising prices, then a bit of a retracement, and then resumption of the move to the upside. As a scalper, I want to be in the market when the price action is rising to the upside and would like to avoid the inevitable retracements that occur. Of course, this is much easier said than done because retracements do not generally announce themselves or occur in predictable patterns. On a day when the market is moving to the upside, and it appears that will be the trend for the day, I will immediately add the Parabolic SAR to my chart because it can often tip me off to when those retracements may occur.
Now I bet you are wondering, "how does that work?"
For the sake of example let's assume the market is in an uptrend, so the parabolic SAR indicator would be below the asset price action. As a trader, I would be monitoring the distance maintained between the Parabolic SAR and the asset price. As long as the price stays above the indicator I am comfortable and happy watching the price increase. Inevitably, the gap between the price and the Parabolic SAR begins to narrow and at some point the indicator will cross through the asset price. At that point, I exit the trade and bank my gains. If you have read any of my other articles you will know that I will begin looking for a Fibonacci ambush trade to time my reentry into the market. So in a trending market, which is really the only market I like to trade, I have a very valuable tool in the Parabolic SAR for exiting a trade at the beginning of a retracement.
Of course, many traders like to let their trades run and will hold on to their contracts through the retracement. There is nothing wrong with this, but my scalping mentality tells me to trade with the trend and exit on retracements. If I have accumulated 2 or 3 points on the ES contract for example, I am happy to take my profits as my mission on that trade has been accomplished.
As you can see, I use the Parabolic SAR as a tool in a trending markets to identify retracements. When the Parabolic SAR crosses through the price action (which would indicate a possible temporary move to the downside) I exit and bank my profits. For the record, you can use the same system on short trades, and it works, but the action can be much faster and more erratic when you are working in a downtrend. Depending upon the nature of the downtrend, I may or may not use the Parabolic SAR to start retracements. I wish I could tell you what determines whether or not I use the indicator in a downtrend, but it is more a matter of how I feel the downtrend is progressing.
So give the Parabolic SAR a try and I think you will be pleasantly surprised with the results. There are many trading systems based solely on the Parabolic SAR and they may be worth a look, too. We all trade differently, and certain indicators resonate to a greater degree with different traders.
