Some of the most powerful moves in the financial markets occur when a trend builds. Once a trend takes hold, it may often exceed general expectations for how long it will persist, leaving only the most skilled traders to profit to the maximum. Being able to properly analyse trending states of the market is therefore an extremely useful ability, which is exactly why there are so many different tools that attempt to do the job. This article is going to take a look into one of the major indicators in the area: namely, the Parabolic SAR indicator.
First of all, what does Parabolic SAR mean? It simply stands for 'parabolic stop and reverse'. You see, the indicator doesn't simply identify trends; it also tells you when to close out your trade and reverse direction. Sounds pretty useful, doesn't it?
The indicator is one of a clutch of trading techniques developed by J. Welles Wilder, a commodities trader and hugely influential technical analyst. His book New Concepts in Technical Trading Systems introduced some of the cornerstones of modern technical methods, including Average True Range, Relative Strength Index as well as what he called the parabolic time/price system. This last item is, of course, the indicator we're focusing on, the Parabolic SAR indicator.
The indicator plots a curved pattern on a price chart, as we will see, which describes potential stop and reverse levels. The shape of this pattern reminded Wilder of the familiar parabolic curve found in classical geometry and mechanics – this is where the indicator's name comes from.
In the next section, we're going to look at how we calculate the indicator. Looking at the calculations behind the indicator can aid your understanding of how it works, what the various parameters mean and how to modify its usage. Remember that although it is useful to know, it's not strictly necessary. This is because MetaTrader 4 will take care of all the calculations for you. If you just want to get on to how to use the indicator, skip on to the next section. Otherwise, read on.
As we said above, the indicator plots stop and reverse levels on the chart. These are calculated from the Parabolic SAR formula, which is as follows:
SARNEW = SARCURRENT + AF x (EPCURRENT - SARCURRENT)
Where the formula terms are defined as below:
AF = acceleration factor – a changing value that increases in set increments for each period that a new high (for long positions, or new low for shorts) is reached for the trade. Wilder proposed a value of 0.02 for the initial value of AF, which would then increase in steps of 0.02 until it reaches a maximum value of 0.20.
EP = extreme point, the highest or lowest price seen for the duration of the current trend (highest for an uptrend, lowest for a downtrend).
The curve of the indicator is intended to provide a guide to the path of a trending market. Wilder contended that a trending market will have a high probability of remaining within the constraints of the curve on the chart. It follows that if the price fails to do this and instead breaks through the curve, the trend may have run out of steam.
It is at such points in time that you should stop and reverse your position.
That's it for the theory behind the Parabolic SAR indicator. Let's now move on to actually putting the indicator into use with MetaTrader 4.
MetaTrader 4 comes bundled with 30 core technical indicators. Fortunately for our purposes, the Parabolic SAR is one of those indicators – this means, you will have access to the indicator as soon as you install MetaTrader 4. In other words, we don't need to make a separate Parabolic SAR indicator download.
You can find the Parabolic SAR in MetaTrader 4's Trend subfolder in the list of Indicators in the platform's Navigator. Double-clicking on the indicator launches a dialogue window as shown in the image below:
There are really only two key settings as you can see from the parameters shown in the image above. These are listed as Step and Maximum in MetaTrader 4. Step is the size of the acceleration factor. The default value is set at 0.02. The acceleration factor starts with this value and then increases by the step size with each new high (or low for short positions), up to the value defined by the maximum parameter. The default maximum value in MT4 is 0.20, as shown above.
So what are the best Parabolic SAR Indicator settings?
Ultimately, it's a little like asking how long is a piece of string. Which is to say, the answer will depend on your own style of trading. The time frame you are trading on as well as the aims and objectives of your particular trading strategy will all have a bearing. You'll be able to discover what parameter values work best for you through experimentation, though the default values are certainly a sensible place to start.
Generally speaking, the smaller the acceleration factor, the less closely it will trail the price. Conversely, the higher the acceleration factor, the closer it will move to the price. Consequently, a reversal is more likely the higher the acceleration factor. It's important not to have too high an AF or you will reverse too often and fail to properly ride each trend.
Of course, whether you want a higher or lower sensitivity to the price, and therefore more or fewer reversals, is tied to your trading aims. For example, the best Parabolic SAR settings for scalping will likely need more reversals than a long-term, trend-following style – thus, a scalper may find a higher AF more appropriate.
Wilder found that the default value of 0.020 worked best for him, but said anything between 0.018 to 0.021 would work well. He recommended not setting the maximum as anything higher than 0.22 – still, the best way for you to settle on your own ideal settings is through trial and error.
Actually testing different values and seeing for yourself which yield best results in tandem with your own strategy will give you confidence in your methods. To do that, though, you need to be able to give it a go without risking money, which is why it's so useful to have access to a Demo Trading Account.
I added the Parabolic SAR to a Forex chart of hourly EUR/USD in MetaTrader 4, and the result is shown in the image below:
The green dots mark where you should place your stop level. Notice how the stop always trails the market movement – the stop only ever moves closer to the market and never moves further away. As the trend continues, the increasing acceleration factor means that the stop moves closer to the price. If the market does not continue to move favourably, the indicator tells you to stop and reverse.
This is really quite simple, and it follows that Wilder's rules for the SAR trading are not particularly complicated.
The guidelines for Wilder's Parabolic SAR strategy are as follows:
You can look to improve your Parabolic SAR indicator strategy by using other indicators as an aid tool in your decision-making. For example, it can be useful to use a different trend indicator, such as the ADX, to establish that you are in a trending market, as opposed to a range-bound, sideways moving market. It's important to note that the Parabolic SAR is not designed to work in a sideways market.
Knowing the overall direction of the long-term trend can also be useful for placing your opening trade – you may find it advantageous to only place an opening trade in the direction of the overall trend, as defined by another trend indicator. Taking this line of thinking a step further, an alternate method of trading is to only take trades in the direction of the overall trend, closing them out when the price crosses the SAR, rather than actually reversing.
When choosing which supplementary indicator to use in order to support your Parabolic SAR strategy, you might find it useful to pick from a wider selection than just the standard list of the MetaTrader 4 indicators. MetaTrader 4 Supreme Edition is a plugin for MT4 that allows you to substantially expand the array of tools at your disposal. It even comes with a powerful Trading Simulator that allows you to easily backtest your strategies and objectively measure their effectiveness.
J. Welles Wilder said the Parabolic SAR "squeezes more profit out of an intermediate move (which lasts for two or three weeks) than any method I know". Decades have passed, but the tool remains widely used, which is a testament to its effectiveness.
Furthermore, the indicator can be tailored to a wider cross-section of time frames than the quote above suggests. There is no reason to think you cannot apply a stop and reverse strategy to shorter time frames, such as tick charts, as well as to much longer ones, such as daily or weekly charts. The general principle remains the same across them all, provided you are trading in a genuinely trending market.
We sincerely hope you find the Parabolic SAR to be a useful trading tool.