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What Forex Traders Need to Know About Parabolic SAR

Parabolic SAR, also known as Parabolic Stop and Reverse, is a common indicator mainly for short-term traders, although it can be used by longer-term traders, too. 
 

This indicator is a bit different from many others as the idea is to stay in the marketplace all the time. That being said, though, it can be used however it suits the trader. As the Parabolic Stop and Reverse indicator is built into the Metatrader platform, a lot of traders have at least experimented with it.

The indicator focuses on the direction of the price of a financial asset, and it gives a quick heads up as to when the market may be changing directions. The Parabolic SAR was developed by J Welles Wilder Jr., who also created the RSI, or the relative strength index. That being the case, the market took to this indicator relatively quickly, as the author is well known and respected.
How to add Parabolic SAR to Metatrader charts

Adding Parabolic SAR to your Metatrader charts is very simple. All you need to do is click on Insert, pull down the menu and click on Indicators, followed by Trend. After that you simply select Parabolic SAR to attach it to the chart. As it is built into the platform, there is no need to download from an external place.

Inserting the PSAR on Metatrader charts

At this point, you have a couple of potential inputs, including the Step and Maximum indications, along with the style of the indicator itself. Most people will use the standard settings, so this is how we will present it in this article.

If you don’t yet have Metatrader, you may want to consider opening a demo account and learn how to trade using virtual funds before risking your own capital.

How to read the indicator

The Parabolic SAR plots dots on the chart, showing the direction of the short-term trend. When the dots are below the candlesticks, it suggests that there is buying pressure underneath, pushing the market higher. You will notice how these dots run in consecutive strings, keeping the trader in the trend longer than they may be willing to get involved in without them. 


The idea is that the indicator tells you which direction the market is moving, but it also tells you where to put your stop loss. The stop loss goes at the dot, and if it gets hit you will notice that the dots switch sides, changing the overall trend. For example, if the dots are underneath candlesticks, then you are a buyer with your stop loss moving every time the new dot is presented. Eventually, the market hits that stop loss, and then flips the direction of the indicator, telling the trader to switch the direction in which they are trading.

PSAR indicator on the chart

 

There are a couple of things that should be noted here, for example that this is a trending type of indicator. It also gives a bit of a wide berth for stop losses, so it is easier to deal with this indicator and use it effectively on shorter-term charts. In fact, that’s how most traders use it. 
 

Take a look at the following chart. It’s a 15 minute GBP/AUD pair chart and notice that although there were some whipped cells along the way, the trades that work out are quite explosive.

On the chart, you can see that the market rallied quite significantly, then whipsawed a bit, only to rally again. In other words, you probably had two very small losses in comparison to a couple of decent gains. The rollover from the highs of the chart were a nice selling opportunity, followed by a relatively flat market that produced a couple of choppy moves that probably went against you before your stop loss was hit. In other words, it should become apparent that the indicator is not to be used in a range-bound type scenario.

PSAR signals

The one major advantage of this indicator, though, is that it’s completely mechanical, therefore, you know where your stop losses are and you know when it’s time to get out. In a sense, it can be thought of as an algorithm, but was calculated by the trader themselves, as it has been around since before algorithmic trading became really popular. 
 

Quite often, a lot of the issues that you run into with the Parabolic SAR indicator can be smoothed out by following a couple of key points.. After all, the market tends to be very noisy, and does tend to be unidirectional most of the time. Granted, you will get the occasional pullback, but overall trends tend to last much longer than pullbacks do, and therefore most of the money is made hanging onto the trend. It’s in this scenario that the Parabolic SAR indicator shines.


PSAR with the 50 SMA


After that, the market broke above the 50 day SMA and once the Parabolic SAR dot was printed above the 50 day exponential moving average, or EMA, the trader using both of these indicators would have gone long. You can see that the trade lasted for quite some time, before pulling back towards the 50 day SMA again. This allows an opportunity to go long and once the indicator flashed all of the dots underneath, traders would have been buyers.

Just as we saw with the big move higher, the indicator started to flash a sell signal before it crossed over the 50 day SMA, which was a confirmation that you should start selling again. As you can see, this combination can be quite useful. However, in general, moving averages tied into the Parabolic SAR tend to work better with longer-term charts, making it a bit of a hybrid system as the Parabolic SAR itself does well on a shorter time frame. Adding a moving average seems to be even more filtered and reliable, at least on longer time frames.
Add a moving average to use Parabolic SAR longer term If you add a moving average to the chart, that can give you an idea about the overall trend. When used with the Parabolic SAR indicator, it helps you avoid potential losses. For example, look at the several red arrows at the beginning of the chart below on the AUD/NZD daily chart.

The red arrow shows you when the market has broken below the 50 day simple moving average, or SMA, something that is quite often used to determine the overall trend. With the Parabolic SAR flashing a sell signal, and the dots sitting right around the moving average, this presents itself as a nice shorting opportunity.
Designed as a system, yet not to be used on its own This indicator was originally designed to be a system, but quite frankly it’s not all encompassing. It’s very rare that a particular indicator can give you a reliable trading system by itself, and the Parabolic SAR isn’t going to be any different.

It’s obvious that the indicator is very useful, but it does tend to need a little bit of hell. You can use the Parabolic SAR with the moving average as shown previously, but some traders will also use the indicator only when a particular candlestick pattern appears, perhaps something along the lines of a shooting star or an engulfing candlestick.

That said, the indicator doesn’t perform as well in extraordinarily volatile markets, because it does not have time to react. What you are hoping to see is a steady trend in one direction or the other to take advantage of. Ultimately, the market conditions will dictate the tool you should use.
 

In short, the Parabolic SAR is useful, as it shows: 

  •          The overall trend

  •          Where to place your stop loss

  •          When to change direction 

However, Parabolic SAR has some limitations as: 

  •          It needs a trend

  •          Sideways markets lead to losses 


In summary, this is an indicator that traders should perhaps demo trade initially, using indicators with it to determine whether or not it’s a nice longer-term type trading environment, or whether it’s something you will be using for short-term trades. Remember, indicators don’t have to be used as initially designed, they are simply tools in your toolbox. It is not uncommon to see a professional trader take indicators and use them in a completely new way, and you would do well to experiment with different settings and environments for this indicator.
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