Today, I will introduce you to the Parabolic SAR indicator, discussing its key features, advantages, limitations, and the signals it provides. We will explore how to trade effectively using Parabolic SAR in the Forex market, as well as examine five trading strategies that incorporate the indicator to determine trend direction. Additionally, I will present real market examples to provide practical insights.
What is the Parabolic SAR?
Parabolic SAR, short for “Stop And Reverse,” is a trend-following indicator designed to help traders track price movements with minimal lag. It is widely used across various timeframes to analyze the price action of different assets, including Forex. The indicator’s popularity stems from its ability to offer accurate trend forecasts, making it a valuable tool for traders looking to understand market dynamics.
The primary function of the Parabolic SAR is to identify the direction of the prevailing trend, highlighting whether bulls (buyers) or bears (sellers) are in control of the market. Additionally, it helps traders anticipate trend reversals by signaling potential entry and exit points within trending markets.
The Parabolic Stop and Reverse (SAR) Indicator
The Parabolic SAR indicator, developed by J. Welles Wilder Jr., is part of a series of trend-following tools, including the RSI (Relative Strength Index) and DMI (Directional Movement Index), widely used across various trading platforms. This indicator was designed to help traders maximize profits from trend-based movements by signaling trend direction and potential reversal points.
Key Features of the Parabolic SAR
The Parabolic SAR’s primary function is to identify the beginning and end of trends, along with potential entry and exit points. It does this by placing dots either above or below the price bars, depending on the trend’s direction. In an uptrend, dots are located below the price, while in a downtrend, they are positioned above. When the dots switch sides, it signals a potential trend reversal and alerts the trader to adjust their strategy accordingly.
Unlike some other indicators, the Parabolic SAR does not aim to predict the absolute peak or trough of a trend. Instead, it follows the price movement, enabling traders to adjust their take-profit levels and avoid significant losses by providing clear exit signals.
Application and Best Practices
The Parabolic SAR is versatile and can be used with various financial instruments that exhibit clear trending behavior. However, it is not suited for markets that are moving sideways (flat markets), as it generates numerous false signals in such conditions. To mitigate this risk, Wilder himself recommended applying the Parabolic SAR on timeframes above one hour and avoiding its use in non-trending markets.
For effective use in flat markets, traders can combine the Parabolic SAR with other indicators such as the Bollinger Bands or moving averages. These tools help confirm trend direction, while the Parabolic SAR offers confirmation when the trend gains momentum. As long as the dots remain consistently above or below the price, it indicates trend continuation. Once the dots reverse sides, traders should anticipate a possible trend reversal and consider adjusting their position.
In the provided EUR/USD chart, the yellow-shaded areas highlight instances where the Parabolic SAR signals a reversal, marking the end of the current trend. Outside of these reversal points, the dots consistently align above or below the price bars, indicating stable directional movement. By tracking these signals, traders can identify optimal entry and exit points during trending periods.
How Parabolic SAR is Calculated
The calculation of the Parabolic SAR (Stop and Reverse) involves the use of two distinct formulas depending on the market direction. One formula applies during an uptrend, and another is used when the trend reverses and shifts to a downtrend.
- Uptrend Formula (Long Position): PSAR(i) = (HIGH(i-1) – PSAR(i-1)) \times AF + PSAR(i-1)
- Downtrend Formula (Short Position): PSAR(i) = (LOW(i-1) – PSAR(i-1)) \times AF + PSAR(i-1)
Explanation of Variables:
• PSAR: The Parabolic SAR value at the current period (i) or the previous period (i-1) .
• HIGH: The highest price of the previous period.
• LOW: The lowest price of the previous period.
• AF (Acceleration Factor): A dynamic factor that starts at an initial value (typically 0.02) and increases by a set step (usually 0.02) with each new bar until it reaches a maximum value of 0.2. The AF is designed to accelerate as the trend gains strength, thereby adjusting the sensitivity of the Parabolic SAR to price changes.Acceleration Factor (AF) Formula:
AF = 0.02 + ix \times K
Where:
• ix is the number of periods since the last reversal point.
• K is the step size for the AF increment, generally set at 0.02 by default.The Parabolic SAR is calculated by measuring the price difference between the current and previous periods, multiplying this by the AF, and adding the result to the previous PSAR value. During an uptrend, it tracks the highs, and during a downtrend, it tracks the lows. The AF adjusts dynamically as new extreme price levels are reached, allowing the indicator to become more sensitive as trends strengthen, thus helping traders to anticipate trend reversals with greater accuracy.
How to use the Parabolic SAR and read its signals
The Parabolic SAR (Stop and Reverse) is a trend-following indicator used to determine the direction of the asset’s movement and potential reversal points. Here’s a more logically structured explanation of how to use it and interpret its signals:
• Bullish Trend: When the Parabolic SAR dots are positioned below the price, it indicates that the market is in an upward (bullish) trend.
• Bearish Trend: When the dots are above the price, it signals a downward (bearish) trend.
• A trend reversal is anticipated when the price crosses the Parabolic SAR line, causing the dots to shift to the opposite side.
• Buy Signal: In a downtrend, when a dot that was above the price moves below it, this signals a potential bullish reversal. The appearance of the first dot below the price is a key indicator.
• Sell Signal: In an uptrend, when the dots shift from below the price to above it, this signals a possible bearish reversal.
Parabolic SAR is designed for trending markets, so it does not work well in ranging or sideways markets (when the price moves within a narrow range without clear direction). In such conditions, SAR signals are unreliable and prone to giving false readings.
As the trend strengthens, the distance between the SAR dots increases. A larger gap between the dots indicates a more dominant trend. Conversely, as the dots move closer together, it may signal a weakening trend or an upcoming reversal. The probability of a trend reversal increases when the dots begin to tighten.
Example: Ethereum (ETHUSD) in a Trending Market
In the ETHUSD chart, a Parabolic SAR sell signal occurs when the final dot below the price (marked by a blue circle) shifts to appear above the price bar (marked by a purple circle). This change marks the start of a downward trend. As the price declines, the gap between the dots widens (red area), signaling the intensifying bearish momentum.
Additional Considerations
A more reliable signal occurs when 3-4 consecutive dots appear on the same side of the price. This indicates stability in the trend direction. The closer the dots get to the price, the higher the likelihood of an upcoming reversal.
How to Trade with the Parabolic SAR
Let’s look at real Parabolic trading using the S&P 500 CFD as an example.
The first step is to determine the moment when a new trend begins to form in order to maximize the capturing profits from the trade. The ideal signal is a break in the curve. The blue circle marks the last upper dot of the price bar. It is followed by a gap and the first lower dot is formed showing that the price movement will start to go upwards.
We enter the market at the close of the candle (blue line). Set stop loss at the level of the Parabolic SAR indicator (red line). With each step, we will move it to the level of a new dot where the start of a different price action is spotted.
Eventually, one of the stop orders is triggered (red circle in the chart above). A reverse of the indicator has formed in the chart indicating the end of the upward movement (green circle).
In the chart above, the flat shows a good example of the PSAR not working when the price moves sideways. We can see that all 100% of the SAR trading signals are false. The dot reverses, which indicates a trend reversal. However, the price movement vector is not directed toward the indicator movement, but against it. Thus, if you are a CFD broker, for example, you need to be aware of a sideways market since SAR hides a high risk of losing a great part of your personal finance. There are other financial instruments that work as technical indicators, such as the moving average, relative strength index, and others that can help you make proper trend research and spot potential reversals, sell or buy signals, etc.
Conclusion
The Parabolic SAR indicator is a powerful tool for identifying trends and potential reversals in the market. It excels in trending environments by providing clear buy and sell signals, allowing traders to enter and exit trades with precision. By placing the SAR dots either above or below the price, it visually represents the direction of the trend. However, while it’s highly effective in trending markets, it can produce false signals during periods of price consolidation or sideways movement. To maximize its effectiveness, traders should use the Parabolic SAR in conjunction with other indicators, such as the Moving Average or RSI, to confirm trends and avoid pitfalls in flat markets. Proper use of this indicator can greatly enhance a trader’s strategy, ensuring better risk management and more consistent profitability.
