PSAR – Forex Academy

Introduction

Trend trading is a great way to earn money from the forex market. Any retail trading strategy based on a trend continuation pattern works well when it moves within a trend. Therefore, in this trading strategy, we will take trades from minor corrections using the parabolic SAR towards the trend.

Furthermore, we will use a 100-period exponential moving average to determine the trend. If the price is trading above the 100 exponential moving average, we will consider the trend as an uptrend. If the price is trading below the 100-period exponential moving average, it will consider it a downtrend. We will follow a simple logic by considering buying trades when the market moves up and considering sell trades when the market is moving to drown.

However, there are no specific rules about the period of your moving average. Some traders are comfortable with 100 EMA, while some traders are compatible with 20 EMA or SMA. Therefore, if you’re trading in a lower timeframe, you can use any moving average from 20 to 100 periods. However, we will focus on 100 EMA as it provides good profitability based on swing trading ideas.

Why Should We Use Parabolic SAR?

Parabolic SAR is a forex trading indicator that stands for “stand and reverses.” This trading indicator was devised by J Welles, represented by some dots below and above the candlestick. In an uptrend, dots remain below the price and indicates a bullish pressure once the price is rejected from these dots. Similarly, in a downtrend, the dots form above the price, and the price starts to move once it gets rejected from the parabolic SAR.

In the image below, we can see a clear chart of the candlestick pattern.

Let’s plot the parabolic SAR in the price chart and see how it looks like.

It is visible that in an uptrend, Parabolic SAR is below the price, and in a downtrend, the parabolic SAR is above the price. This is why the parabolic SAR is considered as a stop and reverse indicator.

Furthermore, the parabolic SAR has a built-in stop-loss function. Once the price moves up or down with a new candle, the parabolic SAR changes with the price. Therefore, you can move your stop loss once the price creates a new higher or lower low. Furthermore, you can edit the primary parameter of Parabolic SAR from the indicator’s setting, but in this trading strategy, we will use the default format.

Moving Average with Parabolic SAR

If we use a 100-period exponential moving average, we can catch the major trend direction from the minor correction. The forex market Moves Like a zigzag. Therefore, there is a minor correction in a major bullish trend and minor bullish correction in a major downtrend. If we know the major trend, we can quickly enter the trade from a correction to get the maximum reward from the minimum risk.

In the forex market, parabolic SAR usually provides trading signals earlier than expected, which might create a negative impact on your trading result. Overall, any trend following indicator does not provide a good result when the price moves within a range. In most of the cases, markets follow the trend of about 35% of the time. Therefore, it is essential to filter out the conditions where the market is moving within a range.

We can eliminate the unexpected market behavior by using the 100 moving average as it will provide a more significant trend that will prevent over-trading. In the image below, we can see how the parabolic SAR provides false trading signals when the market moves within a range.

In the ranging market, it would be difficult to make a profit using this trading strategy. Therefore, it is better to use the 100 moving average to get the overall direction of the trend.

Moving Average With Parabolic SAR Trading Rules

Every trading strategy has its unique rules. In the moving average with the Parabolic SAR trading strategy, our main aim is to follow the trend towards the direction of 100 EMA.

Overall, we will follow simple rules as Complex trading rules make it challenging to implement it on the chart. You can make good profits with a simple trading strategy if you can utilize it well with appropriate trade management and money management rules.

Timeframe

The moving average with the Parabolic SAR trading strategy works well in all timeframes from 5 minutes to weekly charts. The longer timeframe will provide better trading results. However, it is better to stick to the 1 hour to daily chart as it can cover fresh moves driven by banks and financial institutes.

Currency Pair

There is no obligation to use a currency pair. However, it is better to use a currency pair that does not remain within a range for a long time like EURCHF. Therefore, all major and minor pairs are good to go with this trading strategy.

Buy Entry (Inverse for Sell Entry)

Identify the price above the 100 periods moving average. If the price is choppy at the 100 EMA, Ignore the price chart, and move to another market.
Identify the parabolic SAR to point dots below the candlestick, which will be a buy signal (above the candlestick is a sell signal).
Later on, place a buy stop order above the candlestick high.
Put your stop loss below the printed dot with some buffer.

Example of Parabolic SAR Strategy

At the image below and see how parabolic SAR provided a buy trade setup.

Notice that the price is moving in a range at the 100 EMA area with a violation. The blue horizontal line represents the support and resistance level, where the price is consolidating. In this consolidation, we will not take any trade.
If you look at the price structure, you can see the price is moving within a range from their resistance to support. On the price move above the 100 exponential moving average, you should put a pending order above the range, projecting that it will break out from the resistance level and create an impulsive bullish pressure.

Stop Loss and Take Profit Set

When you put the pending order above the resistance level, you should put a stop loss below red dots that have appeared below the candlestick. While setting the stop-loss, make sure to use some buffer of 10 to 15 pips.

Later on, hold the price until it points red dots above the price. The red dot above the price will indicate that sellers are entering the market, and there is a possibility to create a new lower low. Furthermore, while sitting the stop loss and take profit, you should follow the basic rules of price action, including the breakout and pullback.

Summary

Let’s summarize the moving average with the Parabolic SAR trading strategy:

You should look for a fresh trending movement above or below 100 exponential moving average.
Parabolic dots below the price will provide buy-entry, and parabolic dots above the price will indicate sell-entry.
You should avoid ranging markets where the price might violate parabolic dots.

Moreover, trade management and good trading psychology are mandatory for every trading strategy. You cannot make a decent profit until you know how to minimize the risk to get the maximum benefit from trade.

Introduction

The Parabolic Stop and Reverse system was presented by Welles Wilder in his classic book New Concepts in Technical Trading in 1978, and he originally calls it The Parabolic Time/Price System.

This system sets stops at points that are closer and closer to the price action as time goes on. Mr. Wilder calls it “parabolic” by the fact that the pattern forms a kind of parabola when charted. The main idea is to give the market room at the beginning of the trade and, as price moves in our favor, gradually tighten the stops as a function of time and price.

The PSAR stop always moves in the direction of the trade, as a trailing stop should do, but the amount it moves is a function of price because the distance the stop level is computed relative to the range the price has moved. It also gets closer to the price action regardless of the direction of the price movement.

PSAR equation

If the stop is hit, the system reverses; therefore, Wilder named each point SAR: Stop and Reverse point.

The formula to compute it is:

SAR_Tomorrow = SAR_Today + AF x (EP_Trade – SAR_Today)

The AF parameter starts at 0.02 and is increased by 0.02 each bar with a new high until a value of 0.2 is reached.

The EP parameter is the Extreme Price point for the trade made. If long, EP is the highest value reached. If short, EP is the lowest value for the trade.

Fig 1: The magenta areas are winners, the yellow are break-even trades, and the pink regions are losers. As we might expect, in congestion areas, the SAR system is a loser.

The PSAR Trading System

PSAR as a naked system isn’t too good, since trades that go against the primary trend tends to fail, and almost all trades fail when the price is not trending. Sudden volatility peaks also fool the PSAR system. See Fig 1, point 18, where an unexpected downward peak reversed the trade in the wrong direction, cutting short a nice trade and transforming it into a big loser.

Fig 2a and 2b show the profit curve for longs and shorts in the EUR/USD 1H EURUSD 2017 chart. As expected, the long-trade graph presents more robustness than the short-trade curve, since the EURUSD had a clear upward trend back in 2017, whereas the short trades lost money. That is an example of how following the underlying trend grant traders an edge.

Fig 2a equity curve for long trades

Fig. 2b – Equity curve for short trades

Anyway, it’s fantastic that using an entry system with absolutely no optimization could deliver such good results as the PSAR system when taking only the trades that go with the primary trend. That shows, also, the power of a good trailing stop.

The naked system isn’t too good at optimizing profits, as well. A profit target makes it a lot better. Fig 3.a and Fig. 3.b shows the improvement after setting an optimal target for longs and shorts, especially relevant on shorts.

A small change in the AF parameter, lowering down to 0.18, to give profits more room run, and the use of profit targets, raised the percent profitable from 41.4% to 48.1. Max drawdown improved from -4.77% to -3.37%, as well, and the avg_win/avg_loss ratio went from 1.69 to 1.78. It seems not too much, but in combination with the increment in percent winners to 48.1% makes it an effective and robust system.

PSAR as a trailing stop

In this section, we’ll study the Parabolic Stop and (not) Reverse system, as it might be called, as the exit part of a trading system.

As an exercise, let’s consider a simple moving average crossover. We’ll use the same market segment that we used in the naked PSAR case. For longs, we’ll use an 8-15 SMA crossover, while, for shorts, a 7-23 SMA will be taken, as this arrangement creates optimal crossovers for the current market.

Figs. 4a and 4.b show the equity curve for longs and shorts, respectively, with a Simple Moving Average Crossover system, acting on its own. No PSAR stops added.

As we see in fig 4a, the long equity curve behaved much better than the short one, although that is due to the EUR/USD trending up. On the short side, even after optimizing its parameters, the crossover relationship is lousy.

Fig 5.a and 5.b show the effect of a PSAR trail stop. There’s almost no noticeable positive effect. The oddity that PSAR, as a system, is more profitable than when it acts as a trailing stop in another system is related to the entry signal. It’s evident that the SAR signal takes place earlier than the SMA crossover, so the PSAR stop isn’t able to extract profits when the entry signal lags its own signal. On the short side, if we take a closer look, we can see that it improves a bit the drawdown.

It may seem that the smart thing to do in a trending market such as the EUR/USD back in 2017 is NOT to trade the short side, at least not mechanically.

Take-Profit Targets

But, it’s impressive how take-profit targets help us extract profits and reduce risk when trading against the trend. Let’s see the equity curves using long and short targets:

We observe that the long equity curve has a bit less drawdown, but, overall, it doesn’t change much. That was expected because the naked crossovers are very good at following a trend, so not very much can be gained using targets.

The use of profit targets is much more noticeable on the short side. It not only presents a higher final profit, but it’s drawdown practically disappeared, allowing us to better extract profits against the prevailing trend. We have to be cautious, though, if we detect a major trend change and adapt the targets accordingly.

Conclusions

Throughout this article, we tried to understand and analyze the PSAR as, both, an entry-exit system and its behavior as trailing stop to be used with other entry systems. We spotted its strengths and its weaknesses.

Given the results of our present study, we can conclude that:

The PSAR is a decent system if we combine it with a market filter and profit targets.
Trailing stops, even sophisticated ones, such as PSAR, doesn’t solve our problem of whipsaws when we trade against the trend.
By tweaking a bit the AF parameter down to .18, we were able to improve the trend following the nature of PSAR. Consequently, it is advisable to adapt PSAR to the current market volatility.
The best tool we own to profit using counter-trend strategies is profit targets, optimized to the current swing levels of the market.

References:

The definition of the PSAR is taken from New Concepts in technical trading, Welles Wilder.

The studies presented were made using Multicharts 11 trading platform programming capabilities, and its results and graphs were taken from its System Performance Report.