J. Welles Wilder, the developer of the well-known and commonly used Relative strength index RSI leading indicator developed the parabolic stop and reverse indicator, commonly known as the "Parabolic SAR," or "PSAR" . The PSAR is a trend-following indicator, displayed as a single parabolic line (or dots) underneath the price bars in an uptrend, and above the price bars in a downtrend.
The PSAR’s primary functions are:
1- It demonstrates the current trend
2- Points potential entry signals
3- Points potential exit signals
The objective behind developing the PSAR is to find a trading system that maximizes profits from trend movements. The PSAR allows the trader to calculate both the beginning of a new trend and its end. The indicator can be used on any tradable instrument and on any timeframe.
Fig (1) Source: developed by the author
Parabolic SAR calculation:
The PSAR indicator is already available on all price charting software, the calculation is done using algorithms for both uptrend and downtrend accordingly, Traders and analysts don’t need to calculate it themselves, the application will do the job for you however, it is beneficial that the indicator users grasp the concept.
- Uptrend: PSAR = Prior PSAR + Prior AF (Prior EP - Prior PSAR)
- Downtrend: PSAR = Prior PSAR - Prior AF (Prior PSAR - Prior EP)
Where:
- EP = Highest high for an uptrend and lowest low for a downtrend, updated each time a new EP is reached.
- AF = Default of 0.02, increasing by 0.02 each time a new EP is reached, with a maximum of 0.20. The AF factor can be changed on the trading terminal, however, Wilder and most traders using the indicator recommend sticking to the standard value of 0.2
Trading using Parabolic SAR ( PSAR):
As mentioned, the PSAR highly performs in trending markets. That said, it is important to first identify the trend. In an uptrend, dots will be under the price action and vice versa in a downtrend. When a change of trend occurs, dots flip from on side of the price action to the other side, “sell and reverse” SAR action.
Fig (2) Source: developed by the author
Fig (3) Source: developed by the author
The best entry signal to maximize profits is when a change in trend takes place, in other words when the dots flip (the curve breaks) from one side to the other.
In fig (2), the trader waits for the close of the green candle under the black dot followed by the formation of the flipped dot under the following candle, that’s when s/he enters a long/bullish trade. Stop loss levels will be at the PSAR levels and traders should update their stop loss levels whenever the PSAR dots move (apply trailing stop).
The same technique applies when the trend reverses down. The trader patiently waits for the close of the candle under which lies the PSAR black dot, followed by flipping the dot to be above the following candle that’s when s/he enters a short/bearish trade. Stop loss levels will be at the PSAR levels and traders should update their stop loss levels whenever the PSAR dots move (apply trailing stop).
Given that a trend reversal is the main signal for a trader to enter the trade then, it would be used as a stop loss signal as well.
Combining moving averages and leading indicators with PSAR would add benefit to traders’ decisions regarding trend confirmation, and entry and exit signals.
As shown in the figure below fig (4), the PSAR provided an earlier entry signal on the price chart before the price crosses above the 20-exponential moving average (20EMA) and before the leading indicator, RSI crosses above the 50% range.
The PSAR also provided an earlier exit signal before prices crossed the 20EMA) and before the leading indicator, RSI crosses below the 50% range.
In the above case, the trader’s exit level depends on his entry point and risk appetite.
Fig (4) Source: developed by the author
Fig (5) Source: developed by the author
The PSAR doesn’t perform well during sideways (flat) trading as it provides false misleading signals as shown in fig. (5). it is highly not recommended to use the PSAR in this case, other indicators like the Bollinger bands (BB) accompanied by leading indicators like the RSI would be beneficial while in a trading range/ sideways. Moreover, the PSAR demonstrates high sensitivity over small time frames, providing numerous enter/exit signals which might endure loss, wilder recommend utilizing the indicator for a 1-hour time frame and above.
Displaying and Setting the PSAR on Meta trader:
Please click For bigger size
Please click For bigger size
Pros and Cons of the PSAR:
Pros:
The indicator allows the trader to maintain his position within a trend as long as the PSAR dot is moving in the same direction adding, it indicates the strength of the developed trend through the distance between the PSAR dots. The wider the distance between the PSAR dots the more momentum is added to the trend.
The indicator provides few false signals and guides the trader on where to place the stop loss.
The Parabolic SAR insures not trading against the trend
Cons:
The PSAR doesn’t perform well during trading ranges/ sideway trading
On small timeframes, the indicator tends to demonstrate high sensitivity thus signaling false entry/exit levels. It is not recommended to be used for timeframes below 1 hour as stated by Welles Wilder the indicator developer.
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