Here’s a fact. The profits you make from a trade do not count until you exit your trade. This means that if you bought a stock for $10 and it is currently trading at $50, your $40 profit remains unrealized until you exit the trade.
But how do you decide when to exit a trade? Assume that you had exited the above stock when it reached $50. But the stock then rallied further to reach $80. In this case, you would have lost an opportunity to make $30 more from the trade. On the other hand, if you held on to the stock and it declined to $25 within a week, most of your original profits would have been wiped out.
As you can see, it is important to have a good exit strategy in place in order to maximize your profits from your trade. This is where Parabolic SAR can help.
What is Parabolic SAR?
Parabolic SAR, short for parabolic Stop And Reverse, is one of the best technical indicators for identifying the direction of the momentum of a stock. It is a trend following indicator.
Parabolic SAR helps in determining if the price movement has a higher than normal probability of switching direction, i.e, it helps predict the upcoming price reversals.
This indicator is ideal for markets that are trending, and that have long downturns and rallies. In case of a choppy market where the price movement is sideways, this indicator is not ideal, as it can give many false signals.
How To Identify Parabolic SAR On The Chart
Parabolic SAR is one of the easiest and straightforward indicators. The parabolic SAR indicator is shown as a series of dots placed either above or below the stock’s price on the chart. The figure below shows how these series of dots appear.
How To Use Parabolic SAR
The positioning of the dots of Parabolic SAR can be used for interpreting the bullish and bearish signals.
- Dots below the price: Whenever the dot is below the price, it is usually a bullish signal and the momentum is expected to remain in the upward direction.
- Dots above the price: Whenever the dot is above the price, it is usually a bearish signal and the momentum is expected to remain downwards.
When the position of the dots reverses direction and is placed on the opposite side of the price, it signals the reversal of trend. This is typically the ideal entry or exit point of the trade. The figure below shows the buy and sell signals using parabolic SAR indicator.
You can also use Parabolic SAR to determine whether you should exit your trade or not.
Whenever there are more than 3 dots formed in the opposite direction, the reversal is confirmed. If the number of dots is less than 3, it is usually a false signal. This can be seen from the figure below.
From July 20th, the dots were formed above the price, indicating bearishness. Assume that a short position was taken after the third dot on July 25th. On August 16th, more than 3 dots were formed in the opposite direction, indicating bullishness. At this point, the short position should be covered.
Similarly, there were more than 3 dots formed above the price on September 7th, indicating bearishness. Assume that a short position was taken at this point. On October 10th, dots started forming below the price, indicating upward momentum. However, the number of dots was just 3, after which the dots reversed position again. So, there is no need to cover shorts in this case, as the stock’s downtrend is still unbroken.