Traders often ask me how to use pSAR with their charting, and it takes a bit of time to properly explain it. First of all, let’s understand what pSAR stands for and that is “parabolic Stop and Reversal.”
pSAR is the creation of one of the true geniuses in chart theory, an engineer and mathematician named J. Welles Wilder . Wilder has created several tools used by many chartists in modern technical analysis, including RSI and ADX. When one considers how often RSI is used, (and even ADX), then pSAR is another tool that gains quick respect from the best technicians.
Literally, what pSAR purports to do is help a trader decide when is an optimal time to enter and exit a trade. Wilder was looking for a tool that could help a trader decide when these optimal times would occur on a stock chart, and he turned to calculus to devise this tool. Now, most of us are not well schooled in college level calculus, so I won’t go into the formula behind the indicator, but suffice to say, the idea is that when a stock reverses direction, the easiest entry point is early in the new direction.
How often have you noticed that when traders chase a stock that has already had a good run, the trader who chases gets burned by a sudden reversal? It happens every day and hundreds of times, as many of us know. If you have been in this situation (and most traders have!), they may look back and say, “Why didn’t I get in this stock when it first began to run? Look at how it rose each day early in its run without hesitation!”
pSAR attempts to allow for more “space” when a stock first “flips” and moves in a different direction. Then pSAR tightens up it’s stop loss point as a stock continues its trend move. To put this in easy to understand terms, think of an early entry as someone who begins a morning commute into the city from a far flung suburb. When the commuter first leaves his subdivision, traffic is light. He might stop to grab a morning coffee at the local barista shop and he turns up the volume on his favorite morning radio show as the cruise is gentle and quick. The driving is easy at first, but then the commuter enters the main artery (a limited access interstate road) into the big city, and as more on-ramps feed in more traffic, the road suddenly becomes much busier and more congested. The commuter’s ability to maneuver freely or escape the heavy traffic becomes more difficult and any road jam ahead could leave him trapped into a slow and monotonous commute as he nears his final destination.
So, Wilder concluded, and rightly so, that the best time to get on board with a stock is early in its run, although one should be prepared for more volatility in the early part of a run. As you may have heard me say from time to time, “the easy money” is made at the beginning of a run. But how does one know which stocks are about to make a run, and which ones are just dead weight? Again, pSAR helps a trader to spot those stocks that are about to make strong runs (higher or lower–yes, it works for shorts too!) in either direction. (From this point on, I will describe the conditions for a stock that is trading higher, but the same principles can be applied for stocks that are in a sell-off mode.)
So, pSAR allows more “lee-way” early in its move, and then it tightens up as the move continues on the theory that all runs eventually lose momentum and matters will reverse. As most traders know, some stocks seem to take on a life of their own and continue to trade higher each day (or lower in the case of bearish stocks), and technicians call this momentum “trend.” Trend occurs when a stock develops a following that attracts more traders and investors each day and thus, the demand exceeds supply and this drives price up. pSAR helps a trader to see that a trend is in place. Believe it or not, many traders have trouble spotting clear trends. Sure, there are those occasional sky rocket stocks that seemingly explode higher each day–those are easy to spot. However, most stocks that are in a trend situation are moving up a little less noticeably.
To spot a trend, generally, you want to see pSAR stay supportive for 10 or more trading periods–on a daily chart, that would be 10 or more trading sessions in a row. Sometimes, pSAR will show a trend that lasts 20 sessions or more before it reverses. However, 10 is a general rule of thumb, as with some stocks, a true trend may not show up after 10 sessions. It takes time to train the eyes to see this, but some stocks will go 10 or 11 sessions in one direction, and then do the same in another direction–that may not be a trend. On the other hand, you may see a stock that downtrends for say, 5 days on pSAR, and then rallies higher for the next 12 sessions–that may be a clear trend higher in this case.
On most of my charts, I use dots to indicate the pSAR points on a chart….some technicians prefer to use a line, but because most of my charts use a lot of moving average and trend lines, I prefer the dots to make the pSAR points easy to spot (see my chart below and notice the dots above and below the candles on the chart).
Another thing that confuses many novice technicians is the placement of the pSAR points.As I said, pSAR is the function of calculus, and the math of calculus plots the price points on a stock chart. These points represent either support or resistance, just as a trend line would. When pSAR is supportive (bullish), it will show the dots below the price movement of the stock and when pSAR is showing resistance (bearish), it will show the dots “overhead” the price of the stock. These price-points represent potential turning points on a chart. When the dots are underneath the price and so long as the stock price keeps climbing faster than the under-lying dots, then momentum (and a possible trend) is in place. Once the price of the stock reverses and falls below the price point of the pSAR dot for that day, then the dots reverse and they flip to overhead the price.
At first, the pSAR point will be rather far away from the price of the stock on the first day of the reversal. This is the “parabolic quality” of pSAR as it allows for more lee-way early in a new direction or move. As each day goes by and the momentum continues, the dots will draw closer to the price. Wilder constructed pSAR this way for two reasons:
1. Allow wider variance at the early part of the new direction as price will fluctuate more before a trend can become established. The wider variance will help a trader to stay with the trade and not get kicked out by some early volatility.
2. Once the stock develops momentum, and possibly trend, the pSAR points will tighten up closer to the price to help protect the gains that the trader should want to get out of the trade. Assume a trader jumps in on day one of a pSAR flip and rides a stock higher for 20 dots in a row and his stock rises, say 25% in that time, then the dots flip and this is the exit signal for the trader. At the flip point the price might “lock in” a gain of say, 20% for the trader.
When does pSAR work best? Clearly, it works best when a stock is trending in a certain direction. I have had amateur technicians tell me over the years that they think pSAR is not very useful because it “whipsaws” too much. First of all, I agree that it can whipsaw quite a bit, but this actually shows that pSAR is working! A stock that whipsaws pSAR a lot (a few dots higher, then a few dots lower, and a lot of flip-flops back and forth) is clearly a stock that is not in a trend. Thus, I would say to the amateur technician that you have a non-trending stock there, and therefore, they aren’t going to make much money with a trend-less stock! So, indeed, pSAR can tell us that about a lame stock.
However, when pSAR has strung together many dots in a row going higher, then we have a powerful up-trend. If a trader misses this first up-trend, don’t fret! The beauty of trending pSAR is that it is offering a good trader a second chance to enter….on the DDD chart below, you should be able to see this clearly. Before mid-October (2014), DDD had been in a whip-saw mode where the pSAR dots would appear below the stock price for a few days, then flip to overhead for a few more days, and so on. In other words, pSAR was telling us that DDD was trend-less before mid-October.
But in mid-October, DDD began a long rally that would take its price much higher. You can see how the dots stayed underneath (supportive) the price for many days. A trader watching for strong pSAR trend would make note of this and wait for “the flip,” where the dots would reverse to overhead resistance. When this flip occurs after a long trend run (again, generally 10 or more dots in a row), then pSAR is said to go into “weak mode.” Weak mode means that the stock is likely to pull back, but only for a short amount of time, and often for only small price pullbacks rather than a hard sell-off. A weak mode pullback sets up an ideal entry point for the smart trader.
Once the weak mode ends, which is often in 10 sessions or less, then the stock is said to “resume its dominant mode.” The dominant mode for DDD was to go higher and resume its strong upward trend. Sure enough, when the dots flipped back to under-lying support on December 10th, the pullback of DDD was just about over. A smart trader watching for this “trip” signal would have entered (or re-entered or added more shares of) DDD on December 10th or shortly after that date. Sure enough, the strong dominant trend higher resumed, and DDD rallied another $20 from an approximate $77 entry point before pSAR flipped again to a sell signal.
In essence, pSAR tells a trader when to enter a position, and when to exit a position, when pSAR flips again. However, traders who blindly use pSAR without understanding what dominant and weak mode are, will suffer more than they will gain with the use of pSAR. Remember, the best time to use pSAR for entry and exit positions is when pSAR is trending.
pSAR is said to be in trend mode when the dots have stayed in one direction for 10 or more sessions in a row, though this count is a general number, and depending on the stock and its volatility, this rule of thumb can vary. Also, as with all aspects of chart analysis, a trader should not use this indicator in isolation, as many amateur technicians do. Use pSAR in concert with other trend indicators such as MACD and ADX to confirm a trend. When used together with these other indicators, a wise trader will spot true trends more clearly, and will have a better sense of when to enter and exit a trade….as well as avoid deadwood stocks that are trend-less.
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