The Parabolic SAR (Stop and Reverse) is a widely recognised technical indicator that has stood the test of time and is used by many trades to this day. First introduced by J. Welles Wilder in his 1978 book “New Concepts in Technical Trading Systems”, the Parabolic SAR gained popularity as a trend-following tool due to its simplicity and visual appeal. 

By plotting dots above or below the price, the indicator facilitates traders to identify potential reversal points in the market that can theoretically be used as the basis for long or short strategy entry points and, of course, for exit also.

However, like any trading tool, it is worth emphasising that the Parabolic SAR works best when combined with other criteria and considerations and an understanding how it works is necessary prior to developing a trading strategy around this approach to trading reversals.

This article explores how to effectively use it for entry and exit points, discusses its advantages and limitations, and introduces refined methods to improve its reliability.

 

What Is the Parabolic SAR?

In simple terms, the Parabolic SAR is a price and time-based indicator designed to highlight potential trend reversals. Its dots appear:

• Below the price during an uptrend, indicating bullish conditions.
• Above the price during a downtrend, indicating bearish conditions.

As trends develop, the dots “accelerate” closer to the price, making the SAR more sensitive to price movements. This acceleration is driven by a so-called “Acceleration Factor (AF)”, a parameter that increases as the trend continues. 

Ultimately, and as a sign that a trend may be ending, the dots change from below to above and vice versa depending on trend direction.

So, as with any strategy with trend following at its basis this indicator can be used in decision making for such strategies. Before we get into its actual use there are a few noteworthy benefits and limitations worth highlighting.

The chart example below (4-hourly gold CFD) shows the basic concept of SAR dot entry and exit for long and short trades respectively.

 

 

Advantages of the Parabolic SAR

The Parabolic SAR offers a few key benefits that can add to both its ease and method of use, these include:

1. Visual Simplicity: Its dots provide an intuitive, easy-to-read representation of trend direction and potential reversals.
2. Dynamic Trailing Stop: The SAR adapts to price movement, making it a useful tool for managing risk and locking in profits.
3. Trend Confirmation: It helps traders stay in trending markets by signalling when to hold positions or whether it may be worth considering exit.
4. Versatility: Although originally designed for use on stock charts, calculation of the dots happens automatically irrespective of the chart you are applying it to, thus contributing to its popularity through adapting to any instrument (e.g. Forex, index or commodity CFDs) or timeframes.

 

Limitations of the Parabolic SAR

Despite its advantages, the SAR has notable drawbacks:

1. Choppy Market Signals: In ranging or sideways markets, the SAR often generates false signals, leading to unnecessary trades.
2. Lagging Nature: While the SAR adapts over time, as with the majority of platform based indicators, it can lag during fast-moving trends, resulting in delayed exits.
3. Lack of Context: The SAR does not consider market context, previous support and resistance levels, or external factors like news events.

 

Explanation of the Parabolic SAR Settings (PSAR)

The two key default settings of Step (0.02) and Maximum Step (0.20) that you will see when you open the indicator on your trading platform, aim to strike a balance between sensitivity and stability. 

These settings are generally designed to work well in trending markets, and although we usually suggest that when first used, you use the default settings, you will discover in time there may be some benefit in adjustment for different trading styles or market conditions.

 As with all indicators used on your charts, you should not only understand what the indicator is telling you (and what it is not!), but also what settings indicate so that you may adjust to suit your particular trading style and objectives.  

Understanding how these settings affect the indicator’s responsiveness is key to optimising the potential use of this indicator.

 

1. Step (Acceleration Factor):

• Default Value: 0.02
• What It Does:
  • The Step determines the rate at which the SAR dots accelerate toward the price as the trend progresses.
  • Each time a new high (in an uptrend) or a new low (in a downtrend) is reached, the SAR calculation becomes more sensitive by increasing the Step value.
  • The Step starts at the initial value (e.g., 0.02) and increments by the same amount with every new extreme point in the trend.
• Impact:
  • A smaller Step (e.g., 0.01) results in a slower acceleration, making the SAR less sensitive but more suitable for long-term trends.
  • A larger Step (e.g., 0.03 or 0.05) increases sensitivity, making it more responsive but prone to false signals in choppy markets.

 

2. Maximum Step:

• Default Value: 0.20
• What It Does:
  • The Maximum Step is the cap for how far the Step value can increase during a trend.
  • It ensures that the SAR does not become overly sensitive as the trend progresses, which would lead to premature reversals being signalled.
• Impact:
  • A lower Maximum Step (e.g., 0.10) results in fewer reversals being signalled, making the SAR more stable in strong trends.
  • A higher Maximum Step (e.g., 0.30) increases sensitivity and may generate earlier exit signals but can also lead to more false positives.

 

How These Settings Work Together

The Step and Maximum Step settings control how quickly the SAR dots move closer to the price and how responsive the indicator is:

1. At the start of a trend, the dots are further away from the price.
2. As the trend strengthens, the Step increases, bringing the SAR dots closer to the price.
3. Once the Step reaches the Maximum Step, no further acceleration occurs, maintaining stability during extended trends.

 

Examples of the Default Settings in Action

1. Slow and Strong Trends

• With the default Step of 0.02 and Maximum Step of 0.20, the SAR is moderately sensitive:
  • It allows the price some room to fluctuate without immediately signalling a reversal.
  • This is ideal for trending markets where the price steadily moves in one direction.
  • Use a smaller Step (e.g., 0.01) and Maximum Step (e.g., 0.15) for smoother, less frequent signals that may suit swing or long-term traders.

 

2. Short-Term, Volatile Markets

• If you increase the Step to 0.03 or 0.05, the SAR becomes more responsive (and so may suit scalpers or short-term traders):
  • It adjusts faster to price changes, signalling reversals more quickly.
  • However, this can lead to more false signals in sideways or choppy markets.

 

Use the Parabolic SAR for Entry 

Using the Parabolic SAR for entries is most effective when combined with other criteria to filter out false signals. Consider the following refined entry criteria:

1. Dot Switching: Look for the SAR dot to switch from above the price to below (for a long entry) or from below to above (for a short entry).
2. Candle Structure:
   • For long entries, an entry candle close in the top 30% of its range, may suggest bullish momentum.
   • For short entries, an entry candle close in the bottom 30% of its range, may support bearish momentum may be developing.
3. Sequence Length: Confirm that the previous SAR sequence lasted for at least 3 dots. This helps avoid signals caused by short-lived consolidations and retracements.
4. Volume Confirmation: Look for increasing volume during the breakout or reversal, which strengthens the likelihood of a genuine trend shift.
5. Confluence with Additional Indicators: There may be some benefit in combining the SAR with complementary indicators such as the MACD. Look for MACD line crossovers to confirm the trend and increasing momentum as seen in the histogram bar length.
6. Proximity of previous key levels: Close proximity of previous resistance levels or swing highs above a potential long trade may be an indication that upside potential may be limited. Therefore, some caution in entry may be prudent, Obviously, the reverse is the case for short trades i.e. watch for close proximity of previous support or swing lows near short entry,

 

Entry Criteria 2: Alternative approaches

Although not commonly discussed, in an attempt to avoid the risk of a consolidating market with dots frequently switching above and below price there are a couple of additional approaches that may be worth consideration and testing.

1. Using higher timeframe confirmation of trend: This could be using any presence of trend indicator e.g., a 4-hourly chart when trading an hourly timeframe,
2. Using a breach of the price of the first dot of the previous sequence: This may suggest a move out of any potential sideways trend. Let’s call this an “A dot” for this explanation.

The chart example below (GBPJPY 30min) shows using the A-dot of previous SAR dot sequence a breach of which confirms move above potential sideways trend risk and potentially a higher probability trade opportunity (although lesser return) than standard approach. 

 

Exit Criteria: Using the SAR for Reversals

The Parabolic SAR excels at signalling trend exits, especially when a trend reversal is imminent. Here’s how to use it effectively for exits:

1. Dot Switching: A dot switching to the opposite side of the price can serve as an early warning of a potential reversal.
2. Additional Reversal Signs: These can be added to the basic dot switching described above.
   • Candle Structure: Look for candle reversal patterns, such as engulfing candles, Doji formations, or pin bars.
   • Volume Drop: Declining volume near the end of a trend may signal that momentum is fading. Additionally, when the dots reverse there may be an increase in volume as the reversal is confirmed,
3. Trailing Stop: Use the current SAR dot level as a trailing stop to lock in profits as the trend progresses.

 

Summary

The Parabolic SAR is a versatile and visually intuitive tool that can help traders identify trends, manage trades, and spot reversals. 

However, it is most effective when combined with other criteria, such as candle structure, volume, and momentum indicators. If one invests time in measurement and testing then alternative settings can be explored that may better suit your desired trading objectives and strategy choice.

Using alternative approaches as discussed above, may be also worth testing consideration, as well of course, its inclusion within a defined exit strategy.

As with any indicator, while the SAR alone is insufficient for making trading decisions, it has potential as part of a broader trading strategy. By understanding its strengths, limitations, and applications, traders can better harness the power of this classic indicator to navigate the complexities of the markets and instruments and timeframes of choice.

We trust that this article not only adds to your knowledge and trading potential but would be delighted to welcome you to our live events where strategies such as this are discussed and demonstrated live in detail.

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