Definition of the PSAR Indicator:
The Parabolic Stop-and-Reversal (SAR) indicator,
which is yet another indicator developed by Welles Wilder, is designed
to detect trend reversals as well as create a way to trade them. The
indicator is able to create exit points for both long and short
positions in such a way that it allows for reactions or fluctuations at
the beginning of the position, but accelerates upward (for long
positions) or downward (for short positions) as the movement tops out.
The Parabolic SAR appears on the charts in the form of dots. These dots are found below the price action
when prices are rising and above the price action when prices are
falling. In this regard, the indicator will keep on trailing the price
until the price stops and starts to reverse. The best use of the
Parabolic SAR is in trending conditions. If the currency pair is in an
uptrend, then this is a pointer towards long positions. If the trend is
downwards, short positions are assumed.
Usage of the Parabolic SAR in Forex Trading
The three main uses of the Parabolic SAR in forex trading are as follows:
- Determining the trend of the currency pairs.
- Picking out entry and exit points for trades
- As a trailing stop for active trades
The Parabolic SAR can be used alone if it is used as a
trailing stop mechanism to trail advancing price action. However, it
must be combined with other indicators if it is used as a means of
picking tradable signals or in trend determination.
- As a Trailing Stop
The Parabolic SAR tends to trail advancing prices in
an uptrend, or retreating prices in a downtrend. It can therefore serve
as a trailing stop. The question is: how exactly is the Parabolic SAR
used as a trailing stop?
The conventional trailing stop on the trading
platforms is a volatility stop. One complaint many traders have about it
is that it can be too tight and you can never tell when prices have
reversed completely until the trade is stopped out. In contrast, the
Parabolic SAR dots take some time to catch up with the price, and even
at that it still maintains a healthy distance. So when the dot now
appears on the other side, it is a clear signal that the move is over
and it is time to pack up. You will therefore have to move your stop
loss manually to conform to the value of the dot of the Parabolic SAR
while it is still chasing price.
The tightness of the Parabolic SAR lies in the step
settings. A higher step setting will make the Parabolic SAR more
sensitive to price movements. This will however make the trailing stop
function a lot tighter, and we will also see more fake reversal signals.
It is therefore a lot better to leave the step settings as they are by
default.
- Combination of Parabolic SAR with other indicators
We have described at least three strategies where the
Parabolic SAR is used with other indicators to produce tradable
strategies. This is the trend-detection role of the Parabolic SAR in
action. The reason why the other indicators are added, is to get the
exact point of entry for the trade, as well as get trend confirmation.
If you have looked at a typical chart with the Parabolic SAR indicator
on it, you will discover that the buy or sell signals of the Parabolic
SAR appear on the candles even when the trend is nearly flat. So you
will need confirmation that the market will indeed trend so you can
follow the signals with confidence.
PSAR and Stochastics Strategy
The strategy seeks to identify a new trend on the
currency pair. It is best deployed on the hourly chart. This strategy is
a short term strategy which is good for intraday trading.
Indicators Used:The indicators deployed for this strategy are:
- The Stochastics oscillator set to 5,3,3. The indicator is modified by adding a line at the 50 mark. This is what will be used.
- The Parabolic SAR indicator
So how is this strategy setup? This strategy involves
the use of the Parabolic SAR indicator to pick out the trend and using
the Stochastics oscillator as the confirmation for the trade. This is
because the 50 mark is the halfway point of the momentum oscillator. A
Stochastics value between the oversold level and the 50 mark is deemed
to be bullish while a Stochastics value between the overbought level and
the 50 mark is deemed to be bearish.
Multiple time period analysis must be used to pick
the trend direction from the daily chart as well as the 4hr chart. This
provides the direction for the trade on the hourly chart.
Check the trend on the daily chart. Thereafter, step
down to the 4 hour chart and see if it also confirms the trend on the
daily chart. If it does, open the hourly chart and check to see where
the Stochastics lines are in relation to the 50 mark.
The entry is made based on the crossing of the lines
above or below the 50 point, as well as the position of the Parabolic
SAR indicator.
1) Long Entry
A long entry should be made in the following circumstances:
- Trend is on the upside when checked on the daily and 4 hour charts.
- Stochastics oscillator lines cross below the 50 line, showing that asset still has upside momentum. The closer the cross point is to the oversold region, the more room the trade has to move in the trader’s favour.
- Parabolic SAR indicator signal is bullish. Open the long trade at the open of the next candle.
On this chart, we can see that the Stochastics
oscillator has performed a cross below the 50 mark while the Parabolic
SAR indicator was showing a bullish signal. Usually the cross occurs a
candle before the Parabolic SAR starts to show the bullish signal. The
trade is therefore opened on the candle where the Parabolic SAR
indicator shows a bullish signal (the candle on the first or 2nd dot is ok for entry).
Stop Loss
Place the stop loss a few pips below a recent support level such as the recent candle low.
Take Profit
The TP point should be set 50 pips. However, another
way of taking profits may be to wait for the Stochastics oscillator to
reach overbought levels before taking profits.
2) Short Entry
A short trade is performed when a downward trend is
seen first on the daily, chart, and then on the 4 hour charts. Once
this has been confirmed, the trade is setup as follows:
- a) The lines of the Stochastics oscillator should cross above the 50 mark. The closer the cross is to the overbought area, the more room the trade will have to move into profit.
- b) Once the Parabolic SAR dots appear above the candlesticks (bearish signal), the trader should enter short on the open of the next candle.
The short trade setup is shown in this snapshot
above. Here, we can see that the trade entry sets itself up very well
and the currency pair moved quite well too before it headed into
oversold territory. This is where the trader can set the trade exit.
Stop Loss
The trader should set the stop loss a few pips above a recent candle high.
Take Profit
The Take Profit can either be set at a fixed value of
50 pips or can be set at the area where the Stochastics oscillator is
at the oversold area as displayed on the chart.
Conclusion
The extremely short term nature of this trade means
that the trader must observe this trade continuously from start to end.
The trade entry must be practiced thoroughly on a demo account because
this is where most traders miss it. Once the trade entry technique has
been mastered, the placement of the exit point for the trade comes
easily.
