How to Trade Using Parabolic SAR

PSAR Definition

The PSAR, which stands for Parabolic Stop and Reverse, is a popular indicator used in technical analysis to identify the end of market trends and the beginning of trend reversals. This lagging indicator, developed by J. Welles Wilder, can help investors determine the appropriate time to enter a market, and when to place buy and sell orders.

How the Parabolic SAR Works

The Parabolic SAR appears as a series of dots on a chart. Depending on the prevailing market trend, the dots appear either above or below the asset price. If the market is experiencing an uptrend, the PSAR will appear below the asset price, following it as it moves upwards. Conversely, if the asset price is experiencing a downtrend, the PSAR will appear above it, mirroring its downward momentum.

Parabolic Stop and Reversal (SAR)

By following the interpretations provided by the PSAR indicator, traders can identify when a trend is coming to an end, and anticipate impending trend reversals. As we can see in the example above, the PSAR appears below the asset price during an uptrend, but stops when this prevailing trend reaches its end. By using the Parabolic SAR, investors trading this movement are able to anticipate its end, closing their positions when the dots stop forming below the candlesticks. Additionally, any traders waiting for signs of a trend reversal can identify the appropriate time to place an order by using the appearance of the dots above the candlesticks as a sell signal. Investors looking to add the Parabolic Stop and Reverse indicator to their technical analysis should keep in mind that it works most effectively in trending market conditions, rather than during periods of consolidation.

How to Calculate Parabolic SAR

The Parabolic SAR is calculated separately for each trend in asset price, and at each step of the trend it is calculated a period in advance. The formula for this is fairly complex, and differs when calculating Rising or Falling PSAR:

Rising Parabolic SAR Formula:

Current SAR = Previous SAR + [Previous ACF x (Previous EXP + Previous SAR)]

Calculation Example:

(Previous SAR = 1.29 | Previous ACF = 0.02 | Previous EXP = 1.343)

Current SAR = 1.29 + [0.02 x (1.343 + 1.29)] = 1.343

Falling Parabolic SAR Formula:

Current SAR = Previous SAR - [Previous ACF x (Previous SAR - Previous EXP)]

Calculation Example:

(Previous SAR = 1.343 | Previous ACF = 0.04 | Previous EXP = 1.287)

Current SAR = 1.343 - [0.04 x (1.343 - 1.287)] = 1.341

In the formulae above:

  • Previous SAR is the SAR value for the previous period
  • Extreme Point (EXP) is the highest high in the current uptrend or the lowest low in the current downtrend
  • Acceleration Factor (ACF) dictates the sensitivity of the SAR. The value starts at 0.02 and increases by an additional 0.02 every time EXP rises in a Rising PSAR, or falls in a Falling PSAR

There are two exceptions investors must also be aware of when calculating the SAR Parabolic indicator:

  • During an uptrend, the Current SAR can never have a higher value than either of the two previous periods’ lowest values. If this is the case, the Current SAR must be set to equal the lowest of the two previous values
  • During a downtrend, the Current SAR can never have a value lower than either of the two previous periods’ highest values. If this is the case, the Current SAR must be set to equal the highest of the two previous values

PSAR Settings

When adding the PSAR indicator to a chart, investors have a few different settings to consider:

  • Starting Acceleration Factor: By default, this is set to 0.02
  • Maximum Acceleration Factor: By default, this is set to 0.2
  • Acceleration Factor Increment: By default, this is set to 0.02. Depending on the trading platform used, investors may be able to change this value, though this parameter is often set automatically

The default parameters stated above are the most frequently used for the Parabolic SAR. However, depending on the timeframe and the asset being traded, investors may experience improved performance by experimenting with different parameters.

How to Use Parabolic SAR Effectively in Forex Trading

Having explained the basics about the indicator, let’s take a look at how to use Parabolic SAR effectively in Forex trading, under real market conditions. Below is a chart showing the performance of the GBP/USD currency pair in the Forex market, between March and November 2015.

Parabolic Stop and Reversal (SAR)

The asset has been charted at a daily timeframe and the SAR Parabolic indicator has been calculated using the default parameters. As we can see in the highlighted section above, the PSAR forms above the asset price, following its downward movement. As this trend comes to an end, the dots begin to appear below the asset price, hinting at an impending uptrend. Investors trading the currency pair can take advantage of the interpretation provided by the indicator in a variety of ways. Traders already holding short positions can follow the dots created by the Parabolic SAR, waiting for them to start appearing below the asset price, indicating trend reversal. At this point they can close their positions, locking in any profits. Alternatively, traders with no open positions can wait for the reversal to open a buy order and profit from the ensuing uptrend.

Parabolic Stop and Reversal (SAR)

Turning our attention to another point on the chart, we can observe the currency pair experiencing a period of consolidation. This is a good example of the reduced effectiveness of the Parabolic system when an asset is trending within a well-defined range. Although the PSAR continues to correctly identify movements in the asset price, the opportunities for investors to profit during this period are minimal. In such a situation, it is recommended that traders wait out this period of consolidation, and use the interpretations provided by the Stop and Reverse indicator to identify the next significant trend. On this occasion, we can observe that the currency pair experiences a downtrend right after the consolidation period. The PSAR indicator identifies this, as dots start appearing above the candlesticks once again, acting as a sell signal to investors.

Conclusion

As we have explained, the Parabolic Stop and Reverse indicator is an extremely useful technical analysis tool that can help investors identify new market trends and impending reversals. The PSAR provides effective buy signals and sell signals that traders can use to pinpoint the most beneficial time to enter the market. However, the Parabolic system works best during periods of volatility, when market trends are more significant, so investors looking to get the most out of Stop and Reverse trading should avoid using it during times of consolidation.

Did you know?

Between the years 1860 and 1913, the number of foreign banks operating in London increased from 3 to 71.

Word of the day
"Foreign Exchange Market" - The global Foreign Exchange Market is a decentralised marketplace for currency trading. It is the largest and most liquid market in the world.
Pro Tip

Always have an exit strategy.

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