The Parabolic SAR is one of many technical indicators that traders can utilize to pinpoint trends and potential price reversals effectively. This tool can effectively deliver entry and exit signals, and its simplicity in interpretation is a significant advantage. The parabolic SAR indicator, created by J. Wells Wilder (a commodities trader and hugely influential technical analyst), serves as a tool for traders to identify the direction of trends and possible price reversals.
The indicator employs a trailing stop and reverse technique known as "SAR," or stop and reverse, to pinpoint optimal entry and exit points. Traders commonly identify this indicator as the parabolic stop and reverse, often abbreviated as parabolic SAR or PSAR.
This article provides a comprehensive analysis of the parabolic SAR indicator. We will analyze the parabolic SAR formula and illustrate its application in practical scenarios.
What Is Parabolic SAR Indicator?
The Parabolic SAR, or Parabolic Stop and Reverse, serves as a valuable tool for identifying trends. Additionally, as indicated by its full name, it assists traders in determining the optimal moments to close their trades and reverse their positions.
This is part of a suite of trading indicators, such as the Average True Range (ATR) and the Relative Strength Index (RSI). A sequence of dots, contingent upon the prevailing direction of the price movement, represents the parabolic SAR indicator on a chart. During an upward trend, a dot positions itself beneath the price, and during a downward trend, it positions itself above the price.
- When the Parabolic SAR dot is below the currency pair price, it indicates an uptrend and signals to long the trade.
- When the Parabolic SAR dot is above the currency pair price, it indicates a downtrend and signals to short the trade.
The Parabolic Stop and Reverse (SAR) indicator plays a crucial role in assessing both the continuation and potential reversal of prices in currency pairs. We establish the optimal points for entering and exiting positions by analyzing the price levels where the indicator indicates a halt and reversal. These are represented as dots on a price chart, positioned both below and above the currency pair prices.
How to Calculate Parabolic SAR
The dots that make up the Parabolic SAR indicator are derived from the Parabolic SAR formula calculations. There are two distinct formulas to consider, based on the movement of the PSAR indicator—whether it is on an upward trend or a downward trend.
- Rising PSAR = Prior PSAR + [Prior AF x (Prior EP – Prior PSAR)
- Falling PSAR = Prior PSAR + [Prior AF x (Prior PSAR – Prior EP)
AF means Acceleration Factor, which is a changing value that increases in set increments for each period that a new high (for rising PSAR) or new low (for falling PSAR) is reached. Wilder proposed a value of 0.02 for the initial value of AF, which would then increase in steps of 0.02 until it reaches a maximum value of 0.20.
EP means Extreme Point, which is the highest high in the current uptrend or the lowest low in the current downtrend.
Grasping the calculation of the Parabolic SAR indicator can enhance your comprehension of its functionality, the significance of its various parameters, and how to adjust its application effectively.
There's no need for you to be concerned about manually calculating the Parabolic SAR formula. Fortunately, both MetaTrader 4 (MT4) and MetaTrader 5 (MT5) will handle the PSAR calculation on your behalf.
What Does the Parabolic SAR Indicator Tell You?
The parabolic indicator provides buy or sell signals based on the movement of the dots as they transition from one side of the asset's price to the opposite side. For example, the dots indicate a buy signal when they shift from above the price to below it, and they indicate a sell signal when they shift from below the price to above it.
Traders utilize PSAR dots as a strategy for establishing trailing stop-loss orders. For instance, when the price is increasing and the PSAR is also on the rise, it may serve as a potential exit point for long positions. Should the price fall beneath the PSAR, it would be prudent to exit the long position.
The PSAR operates independently of price fluctuations. This indicates that when the price begins to rise but subsequently stabilizes, the PSAR will continue to ascend, even in the face of this lateral price action. A reversal signal is likely to emerge eventually, regardless of whether the price has decreased. The PSAR must align with the price movement to indicate a potential reversal signal. Therefore, one should not interpret a reversal signal on the indicator as a definitive indication that the price is reversing.
The parabolic indicator produces a fresh signal whenever it shifts to the opposite side of an asset's price movement. This approach guarantees a consistent presence in the market, enhancing the indicator's attractiveness to those engaged in active trading. The indicator demonstrates optimal performance in trending markets, where substantial price movements enable traders to realize considerable profits. In a situation where a security's price remains within a defined range, the indicator tends to fluctuate frequently, which can lead to numerous trades that yield minimal profits or even losses.
To achieve optimal outcomes, it is advisable for traders to utilize the parabolic indicator in conjunction with additional technical indicators that assess market trends, such as the average directional index (ADX), moving averages (MA), or trendlines. For instance, investors may validate a PSAR buy signal by observing an ADX reading exceeding 30, along with a rebound from a long-term upward trendline.
How to use Parabolic SAR with MT4 and MT5
MetaTrader 4 and MetaTrader 5 provide a wide range of pre-installed technical indicators, including the Parabolic SAR.
Navigate to the 'Navigator' window on the left side of your screen in both MT4 and MT5 platforms to locate the indicator. Find the 'Indicators' folder in this section, which houses the 'Trend' subfolder—the Parabolic SAR is located there.
After you double-click the icon, a dialogue box will appear, enabling you to modify the Parabolic SAR settings, as illustrated below. When you feel satisfied with the settings, proceed by clicking OK to implement the indicator on your price chart.
Parabolic SAR Settings
'Step' and 'Maximum' are the two key settings.
Step represents the magnitude of the acceleration factor. We establish the standard setting for the step in MT4 and MT5 at 0.02. From this initial value, the acceleration factor increases by the step size with each new high or low, until it reaches the Maximum parameter's limit. Both MT4 and MT5 platforms set the standard maximum value at 0.20.
In general terms, a smaller acceleration factor tends to result in a less precise alignment with the price movements. On the other hand, an increase in the acceleration factor will result in a movement that aligns more closely with the price. As a result, the likelihood of reversal increases with a higher acceleration factor.
Wilder determined that a default value of 0.02 was optimal for his needs, while noting that a range of 0.018 to 0.021 would also yield favourable results. He advised against establishing the maximum at a level exceeding 0.22.
Certainly, the optimal settings will vary based on the specific trader and their unique strategy. While it is generally advisable to begin with the default settings, exploring various values can assist in identifying the optimal Parabolic SAR settings tailored to your needs.
How to Trade with a Parabolic SAR Strategy
The Parabolic SAR is particularly effective for navigating markets that exhibit sustained trends. Positioning the parabolas below the price signals a buying opportunity, while positioning them above the price suggests a selling opportunity. The slope of the parabolas serves as a crucial indicator of the significance of a trend; a steeper slope reflects a more substantial trend, while a gentler slope suggests a less impactful trend.
The Parabolic SAR can serve as a valuable tool for identifying optimal exit points in a trending market. It is advisable to close a trade position when the parabolas transition to the opposite side of the price movement. As previously stated, the ideal moment to validate a trend reversal occurs when three parabolas appear on the opposite side of the price movement. This indicates a potential opportunity to exit a trending position, while the Parabolic SAR can also assist in further analysis.
In active markets, the Parabolic SAR will display a series of consecutive parabolas. These will serve as an effective framework for implementing trailing stops, which can safeguard your capital while also ensuring that you capture gains during strong price trends.
In addition to indicating trends, reversals, and entry and exit signals, the green dots of the Parabolic SAR can also effectively establish stop-loss levels. As the trend progresses, the rising acceleration factor indicates that the stop is approaching the price more closely.
Should the market fail to maintain a favourable trajectory, the PSAR indicator dots will transition to the opposite side of the price, signalling a need to stop and reverse your position. The indicator is straightforward to interpret, and it stands to reason that Wilder's guidelines for trading with the Parabolic SAR are relatively uncomplicated.
The principles for implementing Wilder's Parabolic SAR strategy are outlined below:
- The SAR indicators below the current market price suggest a potential upward trend
- The SAR indicators positioned above the market price suggest a potential downtrend
- Enter a buy position if the PSAR moves below the price or a sell position if the PSAR crosses above the price
- Stop and reverse the position when the price crosses the PSAR again
Drawbacks of the PSAR Indicator
It is crucial to recognize that the PSAR indicator generates signals continuously; not every signal will be precise or result in profitable trades. The image above illustrates several instances of misleading signals throughout the specified timeframe.
As a result, it would be prudent for traders to approach the development of their PSAR trading strategy with greater caution. For instance, rather than immediately altering a position when the PSAR crosses above or below the price, it may be prudent for traders to seek confirmation of a new trend before taking action.
Traders may consider enhancing their Parabolic SAR strategy by incorporating additional indicators to support their decision-making process. For instance, employing an alternative trend indicator like the ADX can be beneficial in confirming whether you are in a trending market rather than a sideways moving one. In a sideways market environment, the Parabolic SAR does not perform optimally.
When exploring new trading strategies, it's crucial to first test them on a demo trading account before moving on to live markets.
Conclusion
In short, the Parabolic SAR indicator helps traders with trading signals before the markets change direction. Combining the Parabolic SAR indicator with other technical indicators like Moving Averages or RSI confirms trading signals and helps traders place successful orders.
