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The Parabolic SAR is a traditional indicator, available in all trading platforms. Today we will discuses its behavior and how to use it to trade the markets.
The Parabolic SAR (Stop-And-Reverse) was developed by Welles Wilder to find trends in currencies and to identify reversals of trends. Its main idea is that the longer the trend, the more chance it will stop. The assumption is that price constantly need 'fuel' to continue to rise, and as time passes trend will become weaker and weaker until the reversal.
This the indicator takes into account by introducing the 'Acceleration Factor'. This number is added to the SAR after each bar that is closed. Using the Acceleration Factor the SAR becomes closer to the price as the trend prevails longer, and increasing the sensitivity towards trend-change. This way, it responses slower at the beginning of trends, and identifies reversals quicker when trend is longer.
Trend and Range
The Parabolic SAR works well in trending markets, but generates a lot of whipsaws in ranging markets. Therefore, it should be used with indicators to filter the ranging periods from price. A good indicator for confirming Parabolic SAR signals is the ADX, or Linear Regression Slope. Welles Wilder also shows example of combining the ADX and the SAR in a trading system.
Trailing Stop Loss
The Parabolic SAR is also commonly used as a method of Trailing Stop Loss. Traders use the Parabolic values to set trailing stop loss. It serves as an efficient trailing stop loss that is better than the constant-size stop loss that does not take into account the length of the trend, and the volatility of the market.
Trading rule for the Parabolic SAR is quite simple:
If Parabolic is below price - Buy.
If Parabolic is above price - Sell.
The SAR is calculated recursively, that is, using the value of the previous bar.
The formula is:
SARn = SAR(n-1) + Step * (EP - SAR(n-1))
EP is the highest high reached in a bullish trend, or the lowest low reached in a bearish trend. Using the EP variable the Parabolic SAR is able to account for the security's volatility and to work well under many market conditions.
Step - Acceleration Factor. Increasing the Step parameter will make the indicator more sensitive. It is recommended to use Step of 0.01 when trading Stocks, and 0.02 when trading Commodities or Currencies.
Maximum - This sets the maximum Acceleration Factor, so long trends won't cause the Parabolic SAR to move too quickly. If trend is too long there is a chance of Acceleration Factor becoming so big even small moves will be declared as reversal. This is why the Acceleration is limited by the Maximum variable, which limits the speed the Parabolic SAR moves towards the price.
Fig. 1: Parabolic SAR in action on the GBP\JPY Forex pair
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