Time Decay is an option trading concept. It represents the decline in an option premium, as it approaches expiry. The concept of time decay stems from the limited lifespan of options, beyond which they cease to exist. For this reason, the excess premium called time value that the option price accumulates during the early period of the expiry, melts away quickly as expiry approaches. In other words, the value that has a time dependency is what gets eroded.
This concept of time dependency is also used in Technical Analysis. The idea is to liquidate a position, unless it generates profits over time. Parabolic SAR (stop and reverse), a method devised by J. Welles Wilder Jr., has this theme as its centre.
Construction of Parabolic SAR
Parabolic SAR is a trend following indicator which aims to find potential reversals and hence the name “Stop and Reverse”.
The general formula used for this is:
where SARn and SARn+1 represent the current period and the next period’s SAR values, respectively.
EP (the extreme point) is a record kept during each trend that represents the highest value reached by the price during the current uptrend – or lowest value during a downtrend. During each period, if a new maximum (or minimum) is observed, the EP is updated with that value.
The α (alpha) value, known as the acceleration factor, is typically initialized at 0.02, though traders can customize this value. The acceleration factor increases by 0.02 each time a new Extreme Point (EP) is recorded, meaning every new EP raises the factor, accelerating the rate at which the SAR (Stop and Reverse) approaches the price. To prevent the acceleration factor from becoming too large, it is usually capped at 0.20. Traders can adjust these parameters based on their trading strategies and the instruments involved. For stock trading, a lower acceleration factor of 0.01 is generally preferred to reduce sensitivity to minor price declines, while for commodities or currency trading, a value of 0.02 is often favoured.
The SAR is recalculated for each new period, but there are two exceptions that can alter its value:
- If the SAR for the next period falls within (or beyond) the price range of the current or previous period, it is adjusted to the closest price boundary. For instance, during an upward trend, if the calculated SAR exceeds today’s or yesterday’s lowest price, it is set to that lower boundary.
- If the SAR for the next period falls within (or beyond) the price range of the upcoming period, this indicates a change in trend direction. In such cases, the SAR switches sides.
When a trend reversal occurs, the first SAR value for the new trend is set to the last EP from the previous trend. The EP is then updated to the maximum value for the current period, and the acceleration factor resets to its initial value of 0.02.
Chart Source: LSEG, Geojit Technical Research
Parabolic SAR and real-world applications
The Parabolic SAR is usually denoted in charts as a set of dots that are placed either below or above the price candle/bars. Continuation of the uptrend is signalled if Parabolic SAR dot is below the price and vice versa. Further, a reversal is signalled if the Parabolic SAR shifts to above the price, from below the price on the previous day. In other words, the change in position of the dot signifies two things: one, it signals a change in direction of the trend, and thus a call to book profits from the present trade; two, where the stop loss of the new trade can be placed.
Tips and tricks while using Parabolic SAR
Like any technical indicator, Parabolic SAR works best in certain conditions. How best we can use this indicator depends on how well we know its limitations, and when not to use it. The main limitation of Parabolic SAR is that it does not work well in non-trending markets. While the main benefit of Parabolic SAR is that it gives exit signals in the event of a trend reversal, a sideways market – being prone to quick change in direction – prompts the Parabolic SAR to generate multiple false signals. This can frustrate a trader who may be used to the more accurate signals generated in a trending market.
And again, like all technical indicators, Parabolic SAR gives best results when used in conjunction with other indicators that can serve as confirmation signal. Since, directionality is the Achilles heel for Parabolic SAR, an indicator like ADX or Moving Average, which can provide more insights on a trend’s direction, momentum or a change in the same can make a Parabolic SAR an effective trading set up.
