Using reliable technical analysis indicators is key to making informed trading decisions and maximising profits. One such indicator is the Parabolic Stop And Reverse (SAR) system, which helps to determine where a price trend might end and subsequently reverse.
What is the Parabolic SAR in trading? In this FXOpen article, we explain how the Parabolic SAR works and how to read its signals. We also discuss combining it with other indicators for more robust trading strategies.
What Is the Parabolic SAR Indicator?
How do you define the Parabolic SAR (PSAR)? It is a trend-following indicator that uses a trailing stop and reverse method. It places dots, or points, above or below the candlesticks on a chart depending on the price direction. This helps traders establish the strength of the trend and identify entry and exit points for trades.
The Parabolic SAR was developed in 1978 by J. Welles Wilder, an American technical analyst who also devised the relative strength index (RSI), the average true range (ATR), and the directional movement concept (ADX) indicators.
Wilder recommended using the indicator to establish the direction of a trend and the likely point a reversal starts, then comparing other indicators to gauge the strength of the movement. According to him, the indicator works best in trending markets, with long rallies or declines, which Wilder estimated to take place roughly 30% of the time.
What Is the Parabolic SAR Formula?
The calculation of the Parabolic SAR involves multiple variables and is best understood as two separate calculations. Based on the results, dots will be displayed on the rising and falling SAR.
Rising PSAR = Prior SAR + Prior AF (Prior EP – Prior SAR)
Falling PSAR = Prior SAR – Prior AF (Prior SAR – Prior EP)
EP represents the “extreme point” in a trend, which would be the highest level reached during an upward move or the lowest level reached during a decline.
AF refers to the acceleration factor, which is initially set to 0.02 and rises by 0.02 every time the EP is recorded, with a maximum value of 0.20. Traders can adjust the AF based on their trading strategy and the asset they are trading.
Trading platforms like TickTrader provide pre-set indicators that you can apply to price charts and use as part of your trading strategy.
How to Read Parabolic SAR Signals
The PSAR signals on a chart are straightforward to interpret; they indicate that an asset’s value will either rise or fall. When the indicator’s dots are positioned below the candlesticks, they provide a bullish signal, suggesting the asset is trending higher as the bulls have upward momentum. When the dots are positioned above the candles, they provide a bearish signal, suggesting that the asset is trending lower as the bears are in control and momentum is likely to continue downward.
The dots trail the price as the trend continues over time and reverse position when the direction changes, breaking above or below the price. For example, if the dots are positioned above the price, a flip below the price could signal an uptrend.
As the asset’s value rises or falls, the dots follow slowly at first and then faster to accelerate in line with the trend as it develops.
How good is the Parabolic SAR at providing effective trading signals? As the Parabolic SAR indicator constantly generates signals, it is effective for taking profits during a trend; however, it can create multiple false signals when the market is choppy or consolidating – it is prone to whipsaws more than 50% of the time or when there is no prevailing trend.
When the market consolidates, traders should decide which signals to trade on. For example, during a decline, it would be less risky to make short trades and discard bullish signals.
How to Enter and Exit Trades
The indicator works well for capturing profits by entering a trade during a stable trend. You could take a long position if the price crosses above the dots and sell if the price crosses below them. You would then reverse your position when the price crossed back again.
You could also use the Parabolic SAR to help you determine whether or not to close a position.
The signals it shows are effective for identifying where to set profit targets and stop-loss orders. You can consider taking profit on a position when the price reaches the dots, capturing gains as the trend progresses.
The rising acceleration factor means that a stop loss always trails the price trend by moving closer to the market. In an uptrend, for instance, you could set a stop loss just below the dots and move it to match the indicator.
The price reversing course and dropping below the SAR signals the start of a downward trend. You would place the stop loss just above the dots and move it in line with the indicator.
How to Combine the Parabolic SAR with Other Indicators
Traders combine the Parabolic SAR with other indicators or chart patterns to confirm the accuracy of its trading signals and the strength of the price movement, as Wilder recommended. You might use a stochastic oscillator, moving averages, and/or the ADX.
The stochastic oscillator helps you to determine when an asset is overbought or oversold, which could indicate that it will reverse direction in the short term. You can combine it with the Parabolic SAR to confirm buy and sell signals.
If the dots on the Parabolic SAR move from above to below the price, you could check to see if the lines on the stochastic oscillator are rising above 20, which would indicate the asset is considered oversold. This would confirm the SAR’s bullish signal, and you could open a long position with more confidence.
Conversely, if the dots on the Parabolic SAR switch from below the price to above it, you would look for the stochastic oscillator’s lines to leave the 80-100 area, as this would indicate that the asset is overbought. With this confirmation of the SAR’s bearish signal, you could take a short position.
Combining the Parabolic SAR with moving averages can help to confirm the direction of a trend and determine entry and exit points.
For instance, if the asset is trading below a long-term moving average, a bearish SAR signal becomes more reliable. The price falling below the average indicates that the sellers are in control of the market and that the signal generated by the Parabolic SAR could be the starting point of another move lower. You could then open a short position based on this confirmation.
Conversely, when the asset is trading above a long-term moving average, you might focus on the SAR’s bullish signals and go long. You could still use the indicator to decide where to set a stop-loss order.
Crossovers in moving averages – when a short-term moving average line crosses over a long-term one – also help traders to identify trend reversals early, so combining them with the SAR can detect reversals earlier than would be possible with the SAR alone.
Average Directional Index
The ADX measures the momentum behind a trend. The value fluctuates between 0 and 100, with a reading below 25 denoting a weak trend. The ADX is derived from the directional movement indicator (DMI), which has two lines – when the positive line (+DI) is positioned above the negative line (-DI), the market is trending higher, whereas if the opposite is applied, the market is in a downward trend.
You can combine the Parabolic SAR with the index indicator to determine when to open and close positions.
If the -DI is below the +DI on the ADX and the value is above 25, with the Parabolic SAR below the price line bouncing off support or breaking through resistance, the market is bullish, and you would open a long position.
Conversely, if the +DI is below the -DI, the ADX value is above 25, and the Parabolic SAR is above the price – which is bouncing off resistance or falling through support, the market is bearish, and you would take a short position.
The Parabolic SAR is a simple technical indicator that traders use to identify potential trend reversals and determine entry and exit points for their positions in stocks and other assets. By plotting dots above or below the candlesticks on a price chart, it provides valuable insights into the market’s direction. You can enhance the Parabolic SAR’s effectiveness by combining it with other indicators and analytical tools to validate the signals it generates and gain a more comprehensive view of the market. You can open an FXOpen account to use the Parabolic SAR in developing your trading strategies.
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