Parabolic SAR Indicator
The Parabolic Stop and Reverse known as the Parabolic SAR, is lagging and trend following indicator developed by J. Welles Wilder. He introduced this indicator in his book called ‘New Concepts in Technical Trading Systems’ which was first published in 1978. This book also includes ATR, RSI, and ADX indicators. This PSAR indicator is displayed as a single parabolic line or dots underneath the candles in an uptrend, and above the candles in a downtrend. Traders typically use this indicator to determine the short-term momentum in the market.
The Parabolic SAR has three primary functions:
1. Highlighting the ongoing trend direction.
2. Providing entry signals.
3. Providing exit signals.
When the Parabolic SAR dots move below the candles, it signals the uptrend, and when the dots move above the candles, it signals the downward flow in the market. Let’s look at the basics of the Parabolic SAR and how you can use this indicator in your daily trading activities.
Parabolic SAR Indicator Formula
SARt = SARt-1 + ( a * ( EPtrade – SARt-1) )
Where SARt is the stop and reverse price of the current interval.
SARt-1 is the stop and reverse price of the previous interval.
‘a’ is the acceleration factor.
EPtrade = extreme price for the trade.
Default Settings of PSAR in MT4
The rate of change in this indicator is dependent on the acceleration factor (‘a’ in the above formula). The settings of this acceleration factor can be changed, which we called step. The default setting for the step is 0.02, and its maximum value (EP) is 0.20. SAR’s rate of change means the distance between the SAR and EP. This rate of change setting can also be adjustable by lowering the step.
What are the best settings?
The answer is subjective. For those traders who want smaller stops to protect their profit should use the higher step and higher maximum. For example, a setting of 0.6 for the step and 0.42 for the maximum (EP) would produce a tight stop loss in the market.
Traders who want to avoid getting stopped out prematurely and wants to allow the breathing room in their trades, use the lower step and lower maximum. A setting of 0.01 for the step and 0.02 for the maximum (EP) would be best.
Installing ‘Parabolic SAR’ in MT4 (step by step process)
Parabolic SAR is one of the most popular indicators in the market, and by default, it is available in the MT4 terminal.
Open your MT4 terminal, click on Insert > Trend > Parabolic SAR.
A new settings window will pop up. You can change these settings according to your preference. As we said before, for the tighter stops, it is recommended to use a higher setting and if you don’t want premature stop-outs, it is recommended to use the lower setting.
As you can see in the image below, the Parabolic SAR indicator is applied on the EURUSD, 60 M timeframe.
PSAR Trading Strategy
The primary role of the SAR is to determine the direction of the trend and any changes with respect to that direction. So it is better to pair this indicator with any of the other indicators which are designed to analyze the strength of a trend rather than the direction of a trend. If you combine PSAR with any trend direction indicator, it will only give you two sets of trend confirmation signals. But if you combine it with the indicator which identifies the strength of a trend, it can be used to identify precise entry and exit signals. One of the most common indicators traders use to identify the strength of a trend is the Average Directional Index (ADX).
Combining the Parabolic SAR with ADX Indicator
ADX measures the price movement and indicates the strength of a trend. If the trend reading is strong, another move can be expected. But if ADX shows a weak reading, it means the market is simply going to print the range. If the ADX reading shows over 25, it means the trend is strong enough to trade. One important thing you shouldn’t forget is, any ADX reading above 50 implies the trend is too strong and expects a change in direction.
In the chart below, the ADX value is over 25, which is a favourable market condition for us to make trading decisions around SAR. We can see that the market is in an uptrend. Hence, PSAR can be used to enter a trade, and for placing the trailing stop loss as well.
SAR will provide valid trading signals, only if the value of ADX is above 25
In the chart below, the value of ADX is below 25. This means the trend is weak, and it is risky to enter a trade just based on PSAR.
SAR doesn’t provide valid trading signals if the value of ADX is below 25
Pros and Cons of Parabolic SAR
The primary advantage of the Parabolic SAR is during the strong trending market. This indicator will highlight a strong trend and helps the trader in making trading decisions. It also provides an exit signal during the pullback time.
The major drawback of the Parabolic SAR is that it provides false signals when the market is moving sideways. Since there is no trend in the market, the indicator continuously flip-flops below and above the price. So if a trader relies only on the Parabolic SAR for trade signals, it is hard to make money from the market. So we recommend you to combine this with other indicators, candlestick patterns, or even price action to trade the market.
The Bottom Line
Parabolic SAR is a lagging indicator that traders use to identify the strong trending markets and for placing the stop-loss orders. Do not use this indicator if the market is moving sideways as it generates a lot of false signals. Experienced traders can adjust the default setting from its step and maximum value of 0.02 and 0.20, respectively. But you can change them anytime depending on your trading style. If you want the lower stops, use the higher setting and for the higher stops, use the lower setting.