Forex Trading

In the world of short-term trading, experiences are defined by a trader's ability to anticipate a certain move in the price of currencies. There are many different indicators used to predict future direction, but few have proved to be as useful and easy to interpret as the parabolic SAR. The parabolic SAR is a technical indicator that is used by many traders to determine the direction of currency’s momentum and the point in time when this momentum has a higher-than-normal probability of switching directions. Sometimes known as the "stop and reversal system", the parabolic SAR was developed by the famous technician Welles Wilder, creator of the relative strength index, and it is shown as a series of dots placed either above or below currency’s price on a chart.



Calculation

The Parabolic SAR is calculated almost independently for each trend in the price. When the price is in an uptrend, the SAR appears below the price and converges upwards towards it. Similarly, on a downtrend, the SAR appears above the price and converges downwards.

At each step within a trend, the SAR is calculated ahead of time. That is, tomorrow's SAR value is built using data available today. The general formula used for this is:

SARn+1 = SARn + α(EP – SARn)

Where SARn and SARn+1 represent today's and tomorrow's SAR values, respectively.
The extreme point, EP, is a record kept during each trend that represents the highest value reached by the price during the current uptrend — or lowest value during a downtrend. On each period, if a new maximum (or minimum) is observed, the EP is updated with that value.

The α value represents the acceleration factor. Usually, this is set to a value of 0.02 initially. This factor is increased by 0.02 each time a new EP is recorded. In other words, each time a new EP is observed, it will increase the acceleration factor. This will then quicken the rate at which the SAR converges towards the price. To keep it from getting too large, a maximum value for the acceleration factor is normally set at 0.20, so that it never goes beyond that. For currency trading, it is preferable to use a value of 0.02.

The SAR is recursively calculated in this manner for each new period. There are, however, two special cases that will modify the SAR value:
- If tomorrow's SAR value lies within (or beyond) today's or yesterday's price range, the SAR must be set to the closest price bound. For example, if in an uptrend, the new SAR value is calculated and it results to be greater than today's or yesterday's lowest price, the SAR must be set equal to that lower boundary.
- If tomorrow's SAR value lies within (or beyond) tomorrow's price range, a new trend direction is then signaled, and the SAR must "switch sides".

Parabolic SAR

One of the most important aspects to keep in mind is that the positioning of the "dots" is used by traders to generate transaction signals depending on where the dot is placed relative to the asset's price. A dot placed below the price is deemed to be a bullish signal, causing traders to expect the momentum to remain in the upward direction. Conversely, a dot placed above the prices is used to illustrate that the bears are in control and that the momentum is likely to remain downward.

The first entry point on the buy side occurs when the most recent high price of an issue has been broken, it is at this time that the SAR is placed at the most recent low price. As the price of the currency rises, the dots will rise as well, first slowly and then picking up speed and accelerating with the trend. This accelerating system allows the investor to watch the trend develop and establish itself. The SAR starts to move a little faster as the trend develops and the dots soon catch up to the price action of the issue.

Parabolic SAR and the Short Sale

The parabolic SAR is extremely valuable because it is one of the easiest methods available for strategically setting the position of a stop-loss order. As you become more acquainted with technical indicators, you'll find that the parabolic SAR has built up quite the positive reputation for its role in helping many traders lock-in paper profits that have been realized in a trending environment. You can also see that professional traders who short the market will use this indicator to help determine the time to cover their short positions.

It is important to note that this indicator is extremely mechanical and will always assume that the trader is holding a long or short position. The ability for the parabolic SAR to respond to changing conditions removes all human emotion and allows the trader to be disciplined. On the other hand, the disadvantage of using this indicator it that the signals can lead to many false entries during periods of consolidation. Being whipsawed in and out of trades can often be extremely frustrating, even for the most successful traders.

Complimenting SAR with other indicators

Given the mechanical properties of the parabolic SAR, it is no surprise that it is a favorite among traders who develop their own strategies. In trading, it is better to have several indicators confirm a certain signal than to solely rely on one specific indicator, so most traders will choose to compliment the SAR trading signals by using other indicators such as stochastics, moving averages, candlestick patterns etc.

For example, a reversal of the dots from below the price to above is much more convincing when the price is trading below a long-term moving average than when it occurs when the price is above the moving average. Having the price remain below a long-term moving average suggests that the sellers are in control of the direction and that the recent reversal could be the beginning of another wave lower. Furthermore, a signal is considered stronger each time that an additional indicator confirms the same trend.



Conclusion

The parabolic SAR is a fairly good tool for traders looking for a strategic method of gauging a stock's direction or for portioning a stop-loss order. As illustrated above, this indicator proves to be extremely valuable in trending environments, but it can often lead to many false signals during periods of consolidation. This indicator is simple to implement into any strategy, but like all indicators, it is usually best if it is used in conjunction with other indicators to ensure that all information is being considered.