Parabolic SAR Strategy
The Parabolic SAR Strategy or Stop and Reverse is a technical analysis indicator developed by Welles Wilder. It is used to determine potential reversals in prices as well as pointing to the market direction in the near term. The Parabolic SAR indicator or PSAR for short is visually identified by the dots that are plotted above and below the prices. The PSAR falls under a trend and a momentum indicator and is plotted on the price chart. This dual combination of the PSAR makes it a versatile trading indicator that can also be used to trade by itself.
Of the many uses, the Parabolic SAR is generally used in the following ways:
- Using the PSAR levels as stop or limit levels
- Using the PSAR levels to gauge the short term direction in prices
- Using the PSAR along with a Moving average indicator to determine short term price reversals in a trend
The chart below shows the Parabolic SAR indicator plotted on the chart. The Red/Green arrows are used to depict how the PSAR identifies the turning point in prices.
Parabolic SAR Strategy
The simplicity and the ability to visually see the signals, makes trading with the Parabolic SAR indicator very easy even for complete beginners to trading.
How to trade the Parabolic SAR Trading Strategy
The first step is to apply the Parabolic SAR indicator with the default settings of Step: 0.02 and Maximum: 0.2. The Parabolic SAR indicator and trading strategy can be used on any time frame but traders should be cautious that smaller the time frame the strategy is used, the more chances of taking on risky trades due to the choppiness in the markets on the smaller time frames. The most ideal time frames to trade the Parabolic SAR trading strategy is H4 and above.
After the Parabolic SAR indicator is applied, the next step is to wait for a reversal. When the PSAR plots dots above price, short positions are taken and when the PSAR plots the dots below price, long positions are taken. At the risk of prices turning volatile, we only consider trade set ups where there is also a confirmation by the candlesticks themselves.
When the PSAR indicator plots the PSAR dot above price and there is a bearish candlestick pattern, short positions can be taken with stops placed at the PSAR levels. The chart below illustrates a Sell Set up using the PSAR Strategy.
Parabolic SAR Strategy – Bearish Trade
- We see a bearish Dark Cloud Cover candlestick pattern and on the next candle, Parabolic SAR triggers a sell signal
- Short positions are entered at the closing price with stops at the PSAR
- The stops are then trailed along with the PSAR which prints a new level on every bar that is closed
- The above sell set up which is trailed along the PSAR level eventually see’s the short position being stopped out
The next chart illustrates a long set up example using the Parabolic SAR indicator.
Parabolic SAR Strategy – Bullish Trade
- The candlesticks first showed a bullish engulfing pattern and this was later confirmed with the parabolic SAR triggering a buy signal
- Long positions are taken on the closing prices with stops at the PSAR level
- Stops are then trailed until the long position is eventually stopped out giving a modest profit
Parabolic SAR Strategy – Pros and Cons
The Parabolic SAR Strategy is a simple trading strategy that is easy to use. While traders can be taken as and when the PSAR signals a reversal, its effectiveness can be improved when combined with candlestick reversal patterns as illustrated above. It should be obvious by now that the risk/reward set up using the PSAR strategy is not great but the odds of the probability of the trade closing in a profit is high. Therefore traders need to pay attention to the position size in light of this risk. However, the PSAR trading strategy is versatile and flexible and while it can be traded on its own combining the PSAR indicator with other momentum or trend indicators can help.
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