Parabolic SAR Strategies- ForexAbode.com

Trading With Parabolic SAR

In technical analysis Parabolic SAR (Stop and reverse) is one of the more visual indicators. A series of dots are appearing below and above the price action, slopping up with the moving up price action, and slopping down with falling price action. It is in a way following the price upwards and downwards. The change of the trend is indicated when the dots hit the reversing price action. For example with rising prices, the dots also rise and when the price action reverses and starts moving down, the rising dots hit the price action. However, this indication comes with some time lag. And it comes only after the reversal is confirmed. Now if the reversal of the price action is not with a strong trend, the price may soon reverse back to the original direction and the signal may prove to be a false signal. 

Parabolic SAR does not indicate the trend or the strength of the trend. Hence we should first confirm the trend and then only follow the signal generated by Parabolic SAR.

Use of Parabolic SAR:

1.  Placing the trailing stop-loss orders and also moving the take-profit levels.
2.  Closing the position when the SAR indicates the time is appropriate.

However, matters are not as clear-cut as this, so before discussing each of these situations in detail, let's first determine when we should take a signal generated by Parabolic SAR seriously and when we should avoid it.

Rule #1:  Parabolic Stop and Reverse should not be used in sideways market i.e. where there is no clear-cut trend. In such markets the prices tend to change direction quite often and like a pendulum. Therefore, the first step is to confirm whether there is a real trend in the price action or the market is just having a range movement.

For a confirmation of the rend situation we can check one of the following or even a combination:

a)  ADX: ADX should be over 25 and rising.
b)  A bullish MACD for uptrend and bearish MACD for downtrend, i.e. when the MACD line is crossing and running above the signal line and below it respectively.
c)  A bullish stochastic (crossing and running over signal line) or bearish stochastic (crossing and running below signal line).

Any of these conditions indicate a definite uptrend or downtrend depending on the sharpness of the crossover and the gaps between the signal line and the indicator line.  Once we have confirmed the trend, we can use Parabolic SAR as follows:

1.  Placing trailing stop-loss orders and moving take-profit levels

When there is an uptrend and we have a long position, we can raise our trailing stop-loss levels upwards from previous levels, and can also raise our take-profit targets at the same time. This should be done while we are also checking the technical as mentioned above to make sure that the uptrend is still there and there are no visible signs of reversal. Similarly with short positions: with a downward trend moving stop-loss levels downwards from previous levels. As long as the other indicators do not indicate any slowing of the trend, then we can also move our take-profit levels downwards. Using trailing stop-loss orders and take-profit targets is very important to maximize the gains. It’s an art which needs to be mastered.

2.  Using the parabolic SAR for stopping and reversing the position

Parabolic SAR can indicate a trend reversal, and so can be used for stopping and reversing positions. When we have a long position during an uptrend, the rising dots will close up to the price action when the trend starts becoming slow, and when the price starts going down - the rising dots will eventually hit the down price. This is an indication by SAR that we might be safest to close the position since the price may likely to continue its downward journey.

However, although we can now close the position and open a short-selling position, we must first check the situation of the trend using other technical indicators as described above, and if a downtrend is not yet confirmed we may stop the long (bought) position but should not enter a short position. In that way we can take profit without committing to another position in opposite side as change in the price action might only be a temporary correction and not reversal.

The same principle applies when we have a short-selling position in bearish market (downtrend). When the price reverses and the falling dots hit the price which started moving up, it indicates that we may close the position to take profit. Again we need to ensure if the this is a possible reversal or just a correction before we enter a buy position.  

Summary: Using complementing technical indicators improves the probabilities of better trading decisions. Please also note that normally we should avoid using the combination of competing indicators. By competing indicators we mean the indicators which are for the same purpose but with a different logic. For example Stochastic and MACD. It may not be good to check one indicators reliability with the other indicator. 

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