One indicator that is a favorite among new traders is the Parabolic Stop and Reverse (PSAR). Beginners get drawn to this indicator because of its visual simplicity, plus its primary use coincides with what new traders are hunting for in price direction: reversals. But what exactly is its purpose? Well, in this article, you'll learn the applications of this indicator, and you'll also read about a Parabolic SAR strategy that you could add to your list of technical tools.
What is Parabolic SAR?
The Parabolic SAR was devised by J. Welles Wilder, the same market technician who developed the Relative Strength Index and the Average True Range indicator. It's visualized in the chart as dots that move in conjunction with the price. These dots can either appear above or below the price.
How to calculate the Parabolic SAR
The calculation for the Parabolic SAR requires the EP or the extreme price in a given time frame, an acceleration factor AF (which begins from 0.02 up to 0.20), and the most recent PSAR.
Uptrend Parabolic SAR = Prior SAR + Prior AF (Prior EP – Prior SAR)
Downtrend Parabolic SAR = Prior SAR – Prior AF (Prior SAR – Prior EP)
Parabolic SAR Uses
The PSAR's most common use is to signal reversals. The dots that trail prices are what traders pay attention to since its placement determines if a trend is about to flip.
Bearish Reversal Signal:
The bearish reversal signal for the Parabolic SAR happens when the dots switch from trailing prices at the bottom to the top. It will look something like this.
From this example, notice how the dots followed the upward slope of the price when it moved along the bottom. But after a few bearish candles, the dots had started appearing above the price, and it broke the upward momentum.
Bullish Reversal Signal:
On the other hand, the bullish reversal signal for the Parabolic SAR occurs when the dots shift from the top to the bottom.
As you can see, the price once again changed its direction, and the indicator presaged the shift.
However, spotting reversals with just one dot can be prone to plenty of false signals. A small tweak to that would be to wait out three dots to appear before placing any trades to determine, at least to a certain degree, that the shift in price direction is likely to hold.
2. Trailing Stop-Loss
Another use of the PSAR is for setting a stop-loss. The distance from the dots that signal the reversal to the trading price offers ample margin for setting stop-loss orders.
And as the dots move closer to the trading price, the stop-loss level can also be adjusted to match the PSAR level so that the potential loss is reduced.
The Parabolic SAR is also used for determining the general direction of price action for an asset. Again, if the dots are below the price, it indicates that the market is favoring an uptrend, whereas it's in a downtrend when the dots are above.
Now comes the strategy part. This Parabolic SAR strategy will make use of the dots as possible entries as well as trailing stop-loss levels. It's best to use this with a timeframe not lower than the 1-Day timeframe.
Editor's Note: We've backtested this strategy for a limited period and had fairly decent results. The pips we netted were in upwards of 340 in roughly 30 trades, which is why further testing is necessary. And again, the indicator is very prone to false signals, so proper money management rules should apply.
As you can see, there is no predetermined exit to this trade other than getting stopped out, that's why it's essential to keep the risk confined at 1% for every trade. You can download our position size calculator here to make sure you don't end up losing more than 1% of your account's balance.
Alternative Exit Strategy:
Another way to exit the trade is to close an open position upon seeing a single dot shift from up to down or vice versa.
EN: This strategy is designed to catch and ride movements that would capture at least a hundred pips and above. It's also meant to pare down dollar losses by moving stop-loss levels reactively.
PSAR with ATR
The Parabolic SAR can also be paired with another indicator as a way to manage profit targets and exits. One such indicator is the Average True Range (ATR), which is another Wilder brainchild.
The ATR shows the volatility of an instrument, and the value that it shows for a certain period can serve as the initial stop loss and take profit levels.
For example, if the ATR shows a value of 100 pips for the EUR/USD at the moment. The stop-loss order for a BUY trade could be 100 pips below the market price, and the take profit target is twice that value, which means that it's 200 pips above the current price.
EN: Do remember that these strategies have been backtested on limited data and that further testing is required for you to gain full confidence in using this combination of indicators. You should also consider that past performance may not produce the same results.
The Parabolic SAR fulfills several purposes, but its primary use is for identifying potential reversals, albeit considered by many to be inapt for what it's designed to do. For this reason, it's best to use the indicator in conjunction with other indicators to confirm a change in price direction but with the PSAR serving only as an ancillary tool. The entry points discussed in this article that the PSAR dots present can be a viable strategy for as long as proper risk management techniques are implemented.
Learn How To Backtest
Backtesting is very important aspect of trading as it refines technical strategies of traders. Learn how to backtest the PSAR by reading our article.