Forex Trading Strategies With Parabolic SAR Indicator
The Parabolic SAR has always been looked at as a tool mainly focused on catching the start of new trends.
Developed by Welles Wilder, the Parabolic SAR represents a price-and-time-based trading system.
In his words, Wilder tags it the “Parabolic Time/Price System.” The SAR connotes “stop and reverse,” and functions as the real indicator deployed in the system.
As trend extends over time, its price gets trailed by the SAR indicator. When price finds itself surging, the indicator is aligned below, while when the SAR indicator is aligned above, price is said to be falling.
It is in this vein, the indicator stop and reverses when the trend changes and pops out above or below the candlesticks.
The concept of Parabolic Time/Price System was introduced in Wilder’s 1978 book, New Concepts in Technical Trading Systems.
In spite of its development before the information age, Wilder’s indicator is still relevant in today’s trading environment.
From the image below, you can visualize the dots readjusting from being above price bars during a downtrend to below the candles during an uptrend when the trend reverses into an uptrend.
One very good thing about the Parabolic SAR is that it is quite simple to deploy, and I mean CATEGORICALLY simple.
Ultimately, a buy signal is triggered when the series of dots are below and a sell signal when the series of dots are above.
The Parabolic SAR is perhaps the easiest indicator to interpret since it only dictates if price is going up or down.
Having said that, it is a tool that best fits trending markets, with long rallies and downward spirals.
You should stay away from using this tool when the market is going sideways or choppy.
The formula for the Parabolic SAR is as follows:
SARn+1= SARn + α (EP – SARn)
The truth is you really don’t need to know how to derive this formula in order to build a profitable trading strategy, only if you’re interested in programming trading robots or a Parabolic SAR calculation excel file.
The Parabolic SAR is found on most charting software and has a Parameter setting tagged “Step”, which is also the Acceleration Factor (AF) and the Maximum Step.
The Step is a multiplier that impacts the rate-of-change in SAR. The Step will continue to surge as the trend stretches until it hits a maximum.
Once you decrease the value of the Step, the SAR sensitivity also decreases. SAR is moved further away from price when the value of the Step is reduced, making it less likely to catch a reversal.
Consequently, increasing the Step value, ramps up the SAR sensitivity.
The higher Step value, the closer the SAR moves to the price action, which makes it more likely for reversal to occur.
If the Step is set to a high value, reversal will occur too often, therefore whipsaws are most likely to take place.
In Fig. 1.0 above we increased the Step value on the EURUSD, H4 chart to 0.03 away from its default value of 0.02.
We have reduced the Step value on Fig. 1.1 to 0.009 and have maintained our red vertical lines at the points seen on Fig. 1.0, notice how the SAR dots moved further away from price on Fig. 1.1.
I’ll advice that you play with these settings to determine a good value that will fit the assets you trade as well as time frame you trade on.
Understanding Basic Parabolic SAR Signals
The Parabolic SAR is most effective when used in combination with other tools.
This is largely welcomed because when trading it is better to have several technical tools validate a particular signal than to bank on a single indicator.
1. Impending Filters
In order to be able to filter out some trades, a trader need to take signals that are in the direction of the prevailing trend, but avoid signals that go against the dominant trend.
The Parabolic SAR indicator can be used when trading in an ascending channel as shown on Fig. 1.2.
The chart shows a long-term uptrend in the EURUSD, H4.
Therefore, when the parabolic SAR signals a bullish signal, go long. Exit the position when it signals to sell, thus avoid triggering any sell orders.
The upward pointing arrows indicates buy signals. Exit the orders when the dots realign above the candlesticks.
We did not place downward pointing arrows above the candlesticks to show sell triggers, because the dominant trend is upwards.
In the chart above we can also see that price is moving within an ascending trend channel.
To be able to further filter the alerts from such setups, enter buy signals that occur only near the bottom of the channel (as shown on Fig. 1.2).
Parabolic SAR trading strategies for scalpers
It is possible to scalp the market using the Parabolic SAR along with other indicators, but most importantly, this strategy is best used when the market is trending.
If the market moves sideways or choppy, this strategy doesn’t for the most part function at its finest.
The combination of the 40-period Simple Moving Average, 20-period Simple Moving Average and the Parabolic SAR indicator is used to determine suitable entries on the 1-minute, 5-minute and 15-minute trading chart.
When the 20 SMA crosses above the 40 SMA, a bullish signal is said to be in place.
A confirmation signal is on course when the Parabolic SAR forms below the candlesticks.
Alternatively, if the 20 SMA crosses below the 40 SMA, a bearish signal is said to be in the offing. A confirmation signal is in place when the SAR gets aligned above the candlesticks.
This strategy can be used on any timeframe, and you can decide on using different colors for the moving averages for the sake of better visual clarity.
Find here an example of how we have adapted the Parabolic SAR in the direction of an efficient scalping tool.
Parabolic SAR trading strategies for day traders
Day trading with the Parabolic SAR is quite straightforward as its series of dots can act as active support or resistance levels.
The Parabolic SAR dots acts as active resistance levels during price decline and when price is seen above the series of SAR dots, it is a trigger to go long accordingly.
A good understanding of just how the Parabolic SAR is computed, and how to accurately deploy the technical indicator to day trading is relaxing.
It is actually nice to consider adding a technical indicator that can gauge the strength of the trend.
An example of this is in a Directional Movement Index forex indicator that can determine if an asset is trending or in a consolidation pattern.
This is one way in which you can have confidence in the Parabolic SAR signal alerts, and ignore the SAR signals when the average line of the Directional Movement Index indicator depicts a choppy market.
Most smart day traders frequently deploy the Parabolic SAR to define stop loss as a substitute to generating buy or sell alerts.
If you’re uncertain about the strength of a trend, as an alternative to placing a buy or sell order in line with the SAR signal, it is possible to use the upper or lower SAR dots as trailing stop loss.
If price surges above or dips below the SAR dot, not minding if price is starting a new trend in the opposite direction or not, you can be rest assured that the current trend is about to take a break.
Getting out of the market at this point is always the right step to take.
Check out a trading strategy with Parabolic SAR and MACD here.
Parabolic SAR trading strategies for swing traders
We will use the 4-hour and daily timeframes when dealing with Parabolic SAR swing trading strategies.
The signals on the indicator are reliable when trading a trending market.
This implies that even for swing traders, an additional technical tool(s) is needed to confirm whether the market is range bound or in a trend.
When using the higher timeframes to generate forex swing trading alerts, the general rule is observed:
– A buy signal is triggered when the Parabolic SAR dots forms below the candlesticks.
– A sell is triggered when the SAR dots gets aligned above the price bars.
Avoid trading smaller timeframes like the 1-hour chart or less when trading market swings, because the presence of larger trends in the market can override the little trends that you might get on these shorter timeframes.
Checkout this amazing Parabolic SAR strategy for swing traders.
The Parabolic SAR is a great tool to have in your trader’s toolbox.
Creating a proper Parabolic SAR strategy with a clear understanding of its drawback, can help you enhance the precision of your prevailing trend following system.
Some other technical tools such as the moving average, can help in filtering out some of the many false signals that the SAR is susceptible to.