Before reading this lesson, you should have previously read through:
SAR stands for stop and reverse and it is a trend following indicator, designed to identify the turning point in.
The parabolic SAR is shown on the charts as a series of small ‘dots’ that are placed either above or below the price. When the price isto the upside, the dots are below the price action and when the price is trending to the downside, the dots are above the price action.
It trails the price movement until the price move has finished and begins to.
As the price move comes to an end, the parabolic SAR moves steadily closer to the price until the price ends up touching the dots - the SAR then begins to form on the other side of the price, indicating that the price is changing direction.
The Parabolic SAR can be used effectively for:
- Determining the trend
- Entry and exiting trades
- Trailing stops
The chart below demonstrates the parabolic SAR indicating and then tracking an.
number_1 - SAR indicating an uptrend
number_2 - SAR tracking the uptrend
In the illustration above, notice how the SAR appears below the price as price moves upwards. When the price move is finished, the price touches the SAR, signalling a possible change in the trend to the downside.
number_1 - SAR touches the end of the uptrend, indicating a reversal
number_2 - SAR tracking the downtrend
In the example above, the SAR appears above the price, signalling a. The SAR trails the price down until the price movement is finished and when the price touches the SAR, it changes, signalling the end of the current downtrend and a possible reversal to the upside.
Traders can use the SAR to identify the direction of the trend.
The SAR can also be used for trailing stop losses, moving thejust behind each new SAR that forms, until the price eventually reverses and stops them out in profit.
Combining the SAR with other indicators
The parabolic SAR can be combined with many indicators, however, the most important principle to bear in mind is that the role of the SAR is to determine trend direction and any changes in that direction.
It is best to combine it withdesigned to determine the strength of a trend, not the direction of the trend.
Therefore, do not combine the SAR with another indicator used to determine a trend, as this will only provide two sets of trend confirmation signals.
If the SAR is combined with an indicator that shows the strength of a trend, then when a strong trend has been identified and confirmed, the SAR can be used to determine optimal entry and exit points.
Combining with the ADX
One of the most common indicators used to identify the strength of a trend is the
This indicator measures the price movements and provides a reading to indicate whether the current trend is strong or weak. If the trend reading is strong, then a sustained move can be expected, whereas if the reading is weak then it is likely the market will simply range.
How do you combine the SAR and ADX?
If the ADX reading reaches 50 or above, then there is a strong possibility of the asset stalling and changing direction, so excise caution when the ADX becomes too strong.
If the ADX is reading between 0 and 25, then the trend is considered too weak to trade and the market is likely to be. If the ADX is showing a reading of over 25, then the trend is strong enough to trade.
If the ADX is over 30, then the trend is considered much stronger and it is optimal time to use the SAR to trade.
Reading the ADX and SAR together
The image below shows the ADX as below 25, which means the trend is weak and there is an increased risk in using the SAR to enter trades.
number_1 - ADX below 25
number_2 - Price is ranging; SAR does not provide valid trending signals
You can see that the market is ranging and the SAR does not provide any useful information.
However, in the image below, the ADX value is over 25, which makes the market conditions optimal to base trading decisions around the SAR. You can clearly see that the market is trending and so the SAR can be used to help enter into a trade, as well as for a trailing stop loss placement.
number_1 - ADX above 25
number_2 - Price is trending; SAR providing valid trending signals
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Changing the Parabolic SAR settings
When working with the parabolic SAR, you can change the settings to best fit your personal preference. When the SAR is set further away from price action, it will react slowly and provide less signals, but they are likely to be more reliable. When the SAR is set closer to the price action, it will react more quickly and provide more signals, however they are likely to be less reliable.
To learn how to change your settings to suit your trading style, click on the instructions:
There are two settings for the parabolic SAR:
- Step - also known as the ‘acceleration factor’
Changing the step
The step is a calculation that determines how sensitive the SAR is to the movement of the price action and has a universal default setting of 0.02.
The SAR tracks price based on each new ‘extreme point’ that it hits, and each time a new extreme point is made, the SAR adjusts according to the ‘step’. If the ‘step’ is 0.01, then each time a new extreme point is met, it further increases by 0.01 and so on.
If the step is set to a high sensitivity, then the indicator will track the price closely and detect a change in the trend early. However, there is a trade off, as the sensitivity also results in a higher frequency of ‘false trends’ and losses.
On the other hand, if a less sensitive step is used, then the SAR is likely to provide more reliable signals. However, this increases the possibility of entering the trend after the trend is in full swing.
The illustration below shows the difference between a standard step and a higher sensitivity.
number_1 - Standard step of 0.02
As you can see in the chart above, the standard SAR shows less trend changes than the chart below.
number_2 - Step value of 0.08
In the chart above, the SAR with the more sensitive setting shows more trend changes and ‘whipsaws’.
The first chart, which has a standard step of 0.02, would have kept the trade for a longer duration, while the chart below it, which has a step value of 0.08, would have resulted in several exits.
The only reliable way to determine whether a change in the step settings will be an improvement is to measure the performance of the different settings of the SAR over a series or trades.
The ‘maximum’ setting limits how much the SAR adjusts at each extreme point in the price. The universal setting for the ‘maximum’ is 20. The illustration below demonstrates how the maximum step affects the SAR:
number_1 - Standard setting of 0.2
The image above is the standard setting, which is 0.2, while the image below shows the SAR with the maximum setting adjusted to 0.8.
number_2 - Maximum setting adjusted to 0.8
What is most striking is how little of an impact adjusting the ‘maximum’ step alone has; the two charts look identical despite the change in parameters.
This is because the ‘maximum’ setting is mainly concerned with limiting the effect of the ‘step’ setting, rather than altering the indicator itself. It is designed to stop the ‘step’ setting from increasing exponentially during a very extreme trend, which would result in a skewed reading.
This means that changing the ‘maximum’ setting on its own will have little impact.
Testing the SAR settings
Once you have decided which settings you would like to test, you are ready to begin collecting data to use when comparing results for each setting.
A good place to start is by trading with the SAR on its standard settings.
Youris a great tool for conducting this type of analysis.
Once there is sufficient data from trading with the standard settings, you can carry out the same process with differing settings, each time analysing the results of a series of trades and then comparing these results with the original set.
It is also important to note that the more trades you include in each sample over a longer period of time, the more reliable and useful the results of the analysis will be.
In this article you have learned ...
- ... the parabolic SAR is a trend following indicator.
- ... it can be used to determine a trend and for a trailing stop.
- ... the SAR works in a trending market, not in a ranging market.
- ... combine the SAR with indicators designed to determine the strength of a trend.
- ... you can combine the SAR with the ADX to achieve higher performance.
- ... the settings can be change to make the SAR more sensitive to the price movement.
- ... if you change the settings, the performance should be analysed with a trading journal to see the effects.
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