Parabolic SAR Indicator and Strategy

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Parabolic SAR Moving Average Trading Strategy

In this article, you are going to read about a trading strategy that teaches you how to use a parabolic SAR indicator (Stop And Reversal) trading tool, along with two moving average trading strategies to catch new trends on the reversal. This moving average and Parabolic SAR trading strategy will show you how to use the parabolic SAR indicator effectively and how you can add this trading system into your daily trading techniques.

The Parabolic SAR (PSAR) is an indicator favored by technical traders that captures reversal signals. The Parabolic SAR (Stop and Reverse) was developed by J. Wells Wilder. Wilder was a mechanical engineer best known for his technical analysis developments. He has also developed the DMI (Directional Movement Index), the RSI (Relative Strength Index), and other indicators dear to technical analysts today.

Hopefully, by the end of the article, you will have the right parabolic trend formula, learn what a crossover is, find out buy signals, the best moving average crossover for swing trading, best moving average crossover for day trading, and the best moving average crossover for scalpers. Also, read the hidden secrets of moving average.

The strategy is a dynamic trading tool that is used by many professional traders of every market (Forex, Stocks, Options, Futures). It is best used when the market is trending. If the market is choppy, the market is moving sideways, this tool does not particularly work at its best. Take a look at the Rabbit Trail Strategy if you are interested in trading sideways markets.

This was developed by Welles Wilder when he introduced this into his book in 1978 that was titled, “New Concepts in Technical Trading Systems.”

What this tool basically does is helps traders determine when the current trend will end, or when it is about to end. The way it shows you this is by placing dots that show up above or below the price candle. They appear above or below the current candle for a specific reason. If the dot is above the candle it will be a SELL signal or downtrend.

However, if the dot is below the candle this can be a signal to BUY or an uptrend. When the change occurs (the dot goes from below to above the next candle) this indicates a potential price reversal may be happening.

Some may think why not just trade the dots. When it reverses, just make an entry at that price. Technically you can trade like this and may win some, but this is a very risky way to trade this indicator. You need other tools to validate this potential trend.

As you can see above, if you simply just trade the dots this will frequently happen.

Which is why we use this indicator and two moving averages to determine an entry point. The moving average trading strategy will help verify that a reversal is in fact occurring. Here is another strategy called The PPG Forex Trading Strategy.

The combination of these indicators will give you accurate trend reversal setups.

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This strategy can be used on any time frame on your chart. So day traders, swing traders, and scalpers are all welcome to use this type of strategy.

Here are the indicators you need to apply on your chart to use this trading strategy:

  1. Parabolic Sar strategy: Default Settings
  2. 40 Length Moving Average= Green color in our example
  3. 20 Length Moving Average= Red color in our example

What does the Parabolic SAR calculate?

The parabolic SAR is used to track price changes and trend reversals over time. In order to calculate today’s Parabolic SAR, you will need to know the most extreme price (EP), the acceleration factor (AF), as well as the most recent PSAR. You will also need to determine whether there is currently an uptrend or a downtrend.

In simple terms, if the pair is trading under the PSAR you should sell. If the pair is trading above the PSAR you should buy. There are many ways to trade this indicator. You can trade it with additional indicators or on multiple/different time frames. Nathan Tucci wrote an article in May 2020 that illustrates how the PSAR can be incorporated into a trading strategy. See that article by clicking here and his Forex Trading System article by clicking here. You can also simply trade the Parabolic SAR for longer terms, trending pairs. For example, let me show you this EUR/USD daily chart:

The “extreme price” will either be the highest high or the lowest low that has occurred within the relevant period. Every time a new EP is established, the trend will be updated. The acceleration factor (which begins at 0.02) will increase by 0.02 for each of the first ten times that the EP has been updated (creating a functional AF “ceiling” of 0.20).

The Parabolic SAR (PSAR) calculation is:

  • PSAR= Prior PSAR + Prior AF (Prior EP – Prior PSAR); for uptrends
  • PSAR= Prior PSAR –Prior AF (Prior PSAR – Prior EP) for downtrends

The difference between the uptrend and downtrend formula is whether the second part of the formula is added or subtracted. It’s important to note, without properly identifying the direction of the current trend, your PSAR calculations will be moving in the wrong direction.

Parabolic SAR Forex Rules for Short Trades

Rule #1- Apply Parabolic SAR system and Moving Average indicators to chart

You can choose different colors for the moving averages. The 20 period moving average is Red and the 40-period moving average is Green in this example.

Rule #2- The Parabolic SAR Indicator must change to be above price candle.

Notice how the dots were below the price. The parabolic stop and reversal (SAR) formula showed us that the price stalled out for a few hours and then the dot appeared above the candle.

This is a sign that a reversal may be forming.

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Rule #3- Another element that must occur is the moving averages must cross over.

In a short trade, the 20 period moving average will cross and go below the 40 periods moving average.

So now the 20 period moving average is below the 40 period moving average. However, something occurred that is notable. The dot then appeared below the price candle.

Since the moving averages are telling us that a downtrend is most likely going to occur, we will wait until the dot appears again above price candle to validate this reversal and enter a trade.

Rule #4- Parabolic SAR dot must be above price candle AND moving averages cross to where 20 period MA is below 40 period MA.

Note** One of these elements may occur before the other. The reversal dot can appear before the MA lines cross. Or the Moving averages can cross before the reversal candle. As long as there are both elements, the entry criteria are met.

Rule #5- Enter The Next Price Candle…

Enter (SELL) the very next price candle after the dot appears above the candle. You can see on our chart where we entered the trade. Waiting for one candle after makes sense because this proves to us that this reversal is strong. The moving averages are supporting the downtrend + the dot is signifying a downtrend.

Rule #6- Stop loss / Take Profit

The stop loss you will place 30-50 pips away from your entry. Always look for prior resistance or support to determine a stop loss. In our example, a stop loss was placed 40 pips from entry.

Your exit criteria are when the 20 and 40-period lines cross over again. OR when the dot reverses appears at the bottom of the candle.

This trade would have been a +203 pip profit using the MA cross exit approach. Not too bad.

Some will get out of the trade when the dot appears below the price candle. If that was the case, in this example, you would have got +32 pips instead. Still not bad, but +203 pips sounds a lot better.

So basically you can use either exit strategy. This trade the downtrend was very strong so we stayed in until the MA lines cross. Determine where you are in a trade. If you are up +100 pips and the dot changes to reversal consider getting out then and taking your profit.

Note** Scalpers should not be using a 30 to 50 pip stop with this strategy. Consider your rules and adjust accordingly. A 5-10 pip stop may be more appropriate on that low of a time frame. If you like this strategy and have a stop you think works best, leave us a comment below and tell us what you think!

Rules for Long Entry.

Rule #1- Apply indicators to chart

Rule #2- Dot must change to be below price candle. This is a sign that a reversal may be happening.

Rule #3– Another element that must occur is the moving averages must cross over.

In a long trade, the 40 period moving average will cross and go below the 20 period moving average.

Rule #4- Dot must be below price candle AND moving averages cross to where 20 period MA is above 40 period MA.

Note** One of these elements may occur before the other. The reversal dot can appear before the MA lines cross. Or the Moving averages can cross before the reversal candle. As long as we have both elements the entry criteria is met.

Rule #5- Enter Next Price Candle. Enter the very next price candle after the dot appears below candle + MA lines cross and 20 period MA is above 40 period.

Rule #6- Stop loss / Take Profit

The stop loss you will place 30-50 pips away from your entry. Always look for prior resistance or support to determine a stop loss.

Your exit criteria in the example below were when the dot appeared above the candle.

This would have been a nice +74 pip profit trade using this strategy.

Conclusion

As stated the Moving Average Trading Strategy can be used on any time frame. However, you should always check different time frames and look at what the market is currently doing. No strategy can give you a 100% win ratio so always be placing your stops at the appropriate areas. I would recommend practicing making both short and long trades with this moving average trading strategy.

Thank you for reading!

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Introduction to the Parabolic SAR

The parabolic SAR attempts to give traders an edge by highlighting the direction an asset is moving, as well as providing entry and exit points. In this article, we’ll look at the basics of this indicator and show you how you can incorporate it into your trading strategy. We’ll also look at some of the drawbacks of the indicator.

Key Takeaways

  • The parabolic SAR indicator, developed by J. Welles Wilder Jr., is used by traders to determine trend direction and potential reversals in price.
  • The technical indicator uses a trailing stop and reverse method called “SAR,” or stop and reverse, to identify suitable exit and entry points.
  • The parabolic SAR indicator appears on a chart as a series of dots, either above or below an asset’s price, depending on the direction the price is moving.
  • A dot is placed below the price when it is trending upward, and above the price when it is trending downward.

The Indicator

The parabolic SAR is a technical indicator used to determine the price direction of an asset, as well as draw attention to when the price direction is changing. Sometimes known as the “stop and reversal system,” the parabolic SAR was developed by J. Welles Wilder Jr., creator of the relative strength index (RSI).

On a chart, the indicator appears as a series of dots placed either above or below the price bars. A dot below the price is deemed to be a bullish signal. Conversely, a dot above the price is used to illustrate that the bears are in control and that the momentum is likely to remain downward. When the dots flip, it indicates that a potential change in price direction is under way. For example, if the dots are above the price, when they flip below the price, it could signal a further rise in price.

As the price of a stock rises, the dots will rise as well, first slowly and then picking up speed and accelerating with the trend. The SAR starts to move a little faster as the trend develops, and the dots soon catch up to the price.

The following chart shows that the indicator works well for capturing profits during a trend, but it can lead to many false signals when the price moves sideways or is trading in a choppy market. The indicator would have kept the trader in the trade while the price rose. When the price is moving sideways, the trader should expect more losses and/or small profits.

The following chart shows a downtrend, and the indicator would have kept the trader in a short trade (or out of longs) until the pullbacks to the upside began. When the downtrend resumed, the indicator got the trader back in.

The parabolic SAR is also a method for setting stop-loss orders. When a stock is rising, move the stop-loss to match the parabolic SAR indicator. The same concept applies to a short trade—as the price falls, so will the indicator. Move the stop-loss to match the level of the indicator after every price bar.

This indicator is mechanical and will always be giving new signals to get long or short. It is up to the trader to determine which trades to take and which to leave alone. For example, during a downtrend, it is better to take only the short sales like those shown in the chart above, as opposed to taking the buy signals as well.

Indicators to Complement to the Parabolic SAR

In trading, it is better to have several indicators confirm a certain signal than to rely solely on one specific indicator. Complement the SAR trading signals by using other indicators such as a stochastic, moving average, or the ADX.

For example, SAR sell signals are much more convincing when the price is trading below a long-term moving average. The price below a long-term moving average suggests that the sellers are in control of the direction and that the recent SAR sell signal could be the beginning of another wave lower.

Similarly, if the price is above the moving average, focus on taking the buy signals (dots move from above to below). The SAR indicator can still be used as a stop-loss, but since the longer-term trend is up, it is not wise to take short positions.

A counter-argument to the parabolic SAR is that using it can result in a lot of trades. The chart above shows multiple trades. Some traders would argue that using the moving average alone would have captured the entire up move all in one trade. Therefore, the parabolic SAR is typically used by active traders who want to catch a high-momentum move and then get out of the trade.

The parabolic SAR performs best in markets with a steady trend. In ranging markets, the parabolic SAR tends to whipsaw back and forth, generating false trading signals.

The parabolic SAR is ‘always on,’ and constantly generating signals, whether there is a quality trend or not. Therefore, many signals may be of poor quality because no significant trend is present or develops following a signal.

The Bottom Line

The parabolic SAR is used to gauge a stock’s direction and for placing stop-loss orders. The indicator tends to produce good results in a trending environment, but it produces many false signals and losing trades when the price starts moving sideways. To help filter out some of the poor trade signals, only trade in the direction of the dominant trend. Some other technical tools, such as the moving average, can aid in this regard.

Moving Average With Parabolic SAR Forex Trading Strategy

Trading the trend in any market is a great trading strategy and using the Parabolic SAR to find reversal points in the direction of the Forex trend makes it even better.

We are going to use the 100 period exponential moving average to show us the trend.

This is a longer period moving average than most people are used to considering the 20 period moving average is the most popular.

For day traders, you could swap out the 100 EMA for the 20 period moving average or even the 10 period MA.

Why Use The Parabolic SAR In A Trading Strategy

J. Welles Wilder invented this trading indicator and the Parabolic SAR stands for “stop and reverse”. In an uptrend, dots form under the price until price reaches a certain point when it flips to the top of price giving you a sell signal.

This is where the Parabolic SAR gets the “stop and reverse indicator” name from. Seeing as Parabolic SAR is a trend following indicator, the “flip” from bottom to top would indicated that longs should close their trading position and then sell the market they are trading.

For Forex traders, that simply means that the quote currency, the second currency in a Forex pair, has gained some strength.

Parabolic SAR Buy Signals – Sell Signals

Any trading strategy that uses the Parabolic SAR has a built in trailing stop function. As price declines for example, the dots will decline as well and seeing as “stop and reverse” is the main feature, you can use the dots as a stop out location.

As with any trading indicator you are using for a strategy, you can make Parabolic SAR move sensitive by adjusting the increment setting. I use the default parameters as over optimizing a trading indicator to make past data look better, is a rookie mistake.

We are going to use the Parabolic SAR to give us both buy signals and sell signals but we will not stop and reverse our trading position.

Using The Moving Average With Parabolic SAR

Using the 100 period exponential moving average will gives us the opportunity to stay inside of the major trend direction while taking only the signals that fall in line with the current trend.

If you were to take every flip of the Parabolic SAR as a trading signal, you could find yourself entering and exiting positions quickly for a loss in a whipsaw market condition. Any trend following indicator is prone to fail in a market that is not trending. Since markets only trend about 35% of the time, you can see a filter will help you stay out of low probability trading conditions.

100 EMA For Trend Direction

Using the 100 moving average will help keep us in line with the larger trend and prevent over trading. Taking a look at the red box, you can see price action is showing consolidation and the Parabolic SAR is flipping back and forth giving buy and sell signals.

It would have been tough trading just taking the buy signals (look closely as some were profitable) even though there was a probability of a larger up move due to the overall trend direction. Taking sell signals as well would have chopped your Forex trading account to pieces.

Parabolic SAR Trading System Rules

Every trading strategy needs rules and the number one rule we will have for the Parabolic SAR strategy that we will use for swing trading is:
trade only in the direction of the 100 EMA.

Our rules beyond that are quite simple. Complex trading rules can lead to you not following the trading plan you have written which leads to a failed trading business. All successful traders follow a written trading plan and I suggest you do as well.

Buy Signals (just reverse for sell signals)

  • We need price to trade above the 100 period moving average. If price is whipping around the EMA, we will choose another market
  • The Parabolic SAR must print a dot beneath a candlestick and that will be our buy signal
  • Place a buy stop order so momentum on the break of the setup candlestick high will take you into the market
  • Use a few pips below the printed dot for your initial stop loss location

Parabolic SAR Trading Setups

Let’s break this chart down to see how the Parabolic SAR signals worked out in relation to the uptrend given by the 100 EMA.

  1. Notice price is whipping around and close to the 100 EMA. The two blue lines are the support and resistance levels of a range that has formed due to consolidating price action. We need to wait until price moves from the moving average before considering any Parabolic SAR trading signals.
  2. Large momentum move and price action and price structure traders can see price is actually sitting on the former resistance level of the range. The white line is the buy signals with the small arrow indicating where you’d place a pending order.
  3. This is where the stop and reverse nature of the Parabolic SAR comes in. We would exit our long position and not take the sell signal due to the trend.
  4. Buy signal occurs when the blue dots appear below the candlestick. We don’t get triggered in the trade due to placing a pending order a few pips from the high of the setup candlestick.
  5. A sell signal is given which cancels the long setup.
  6. Another buy signal is given and price takes off to the upside

Stop Loss Location

The white arrows are showing where the stop loss would be on these trades when triggered. You can see that it is a fairly large stop which would require a smaller position size.

The trades did not trigger at the setup candlestick and as the blue dots climbed upwards while the trade order was still pending, you could alter your stop loss to be in line with the new plotted dots.

Traders who understand price action including pullbacks and breakouts, could use the dots as a potential trading setup.

Alternative Parabolic SAR Trading Strategy

Let’s look at the same chart but with a different trading persepctive

Alternate Trading Strategy

Using a more price action approach, is there a way we can combine the moving average trend direction with the Parabolic SAR buy and sell signals? Yes.

Let’s use the signals to alert us to a potential trading pattern.

  1. The buy signal brings us to the chart where we see momentum move and price consolidating at highs. I talk about this type of setup in my weekly Forex setup updates. We can play the breakout and use the corresponding blue dot for our stop. We can also use the candlestick shown by the green arrow. This is a failure test of lows where we can buy inside the range at the high of that candlesticks
  2. This sell signal alerts us to watch for a price action pattern. Here we get a pullback in price and without a blue dot switching to the bottom, we are not brought into a long trade when price has the little rally in the middle of the pullback
  3. Price breaks out of the trend line with a corresponding buy signal but does not go much further. Price pulls back and the sell signal cancels any trading play
  4. Price action shows a retest of the broken trend line (which we see happen a lot!) and then a break of the down trend line with a corresponding buy signal

You can see that combining price action trading along with trading in the direction of the trend and with the proper SAR signal, we can get some great trades in this Parabolic SAR strategy!

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