What is the Parabolic Stop and Reverse indicator and how is it calculated?
The Parabolic Stop and Reverse (SAR) is a technical analysis indicator that is used to identify trends and potential reversals in the price of a security. It is calculated using the following formula:
SAR = Previous SAR + (AF * (EP – Previous SAR))
Where “AF” is the acceleration factor, “EP” is the extreme point, and “Previous SAR” is the previous period’s SAR value.
The acceleration factor is a variable that determines the rate at which the SAR moves. It is calculated based on the current trend: if the trend is up, the acceleration factor increases with each period, and if the trend is down, the acceleration factor decreases with each period. The extreme point is the highest high in an uptrend or the lowest low in a downtrend.
The Parabolic SAR is typically displayed as a series of dots on a chart, with the dots appearing above the security’s price in a downtrend and below the security’s price in an uptrend.
There are several ways that the Parabolic SAR can be used in an algorithmic trading strategy:
- Trend identification: The Parabolic SAR can be used to identify trends in the security’s price. If the dots are consistently below the security’s price, it can be taken as a sign of an uptrend. Conversely, if the dots are consistently above the security’s price, it can be taken as a sign of a downtrend.
- Reversal trades: The Parabolic SAR can also be used to identify potential reversals in the security’s price. A long position can be taken when the security’s price crosses above the Parabolic SAR, while a short position can be taken when the security’s price crosses below the Parabolic SAR.
- Stop-loss orders: The Parabolic SAR can be used to set stop-loss orders, which are orders to sell a security if it reaches a certain price. A stop-loss order can be set at the level of the Parabolic SAR, so that the security is sold if it reaches that level.
It’s important to note that the Parabolic SAR should be used in conjunction with other technical analysis tools and fundamental analysis in order to provide a well-rounded view of a security’s market conditions.