Parabolic SAR indicator

Reversal Trading Strategy

In this article, you are going to read about a trading strategy that teaches you how to use a parabolic SAR indicator (Stop And Reversal) trading tool, along with two moving average trading strategies to catch new trends on the reversal. This moving average and Parabolic SAR trading strategy will show you how to use the parabolic SAR indicator effectively and how you can add this trading system into your daily trading techniques.

The Parabolic SAR (PSAR) is an indicator favored by technical traders that captures reversal signals. The Parabolic SAR (Stop and Reverse) was developed by J. Wells Wilder. Wilder was a mechanical engineer best known for his technical analysis developments. He has also developed the DMI (Directional Movement Index), the RSI (Relative Strength Index), and other indicators dear to technical analysts today.

Hopefully, by the end of the article, you will have the right parabolic trend formula, learn what a crossover is, find out buy signals, the best moving average crossover for swing trading, best moving average crossover for day trading, and the best moving average crossover for scalpers. Also, read the hidden secrets of moving average.

The strategy is a dynamic trading tool that is used by many professional traders of every market (Forex, Stocks, Options, Futures).  It is best used when the market is trending. If the market is choppy, the market is moving sideways, this tool does not particularly work at its best. Take a look at the Rabbit Trail Strategy if you are interested in trading sideways markets.

This was developed by Welles Wilder when he introduced this into his book in 1978 that was titled, “New Concepts in Technical Trading Systems.”

What this tool basically does is helps traders determine when the current trend will end, or when it is about to end. The way it shows you this is by placing dots that show up above or below the price candle. They appear above or below the current candle for a specific reason. If the dot is above the candle it will be a SELL signal or downtrend.

However, if the dot is below the candle this can be a signal to BUY or an uptrend. When the change occurs (the dot goes from below to above the next candle) this indicates a potential price reversal may be happening.

parabolic-sar

Some may think why not just trade the dots. When it reverses, just make an entry at that price. Technically you can trade like this and may win some, but this is a very risky way to trade this indicator. You need other tools to validate this potential trend.

parabolic-sar-stop-loss

As you can see above, if you simply just trade the dots this will frequently happen.

Which is why we use this indicator and two moving averages to determine an entry point. The moving average trading strategy will help verify that a reversal is in fact occurring. Here is another strategy called The PPG Forex Trading Strategy.

The combination of these indicators will give you accurate trend reversal setups.

This strategy can be used on any time frame on your chart. So day traders, swing traders, and scalpers are all welcome to use this type of strategy.

Here are the indicators you need to apply on your chart to use this trading strategy:

  1. Parabolic Sar strategy: Default Settings
  2. 40 Length Moving Average= Green color in our example
  3. 20 Length Moving Average= Red color in our example

What does the Parabolic SAR calculate?

The parabolic SAR is used to track price changes and trend reversals over time. In order to calculate today’s Parabolic SAR, you will need to know the most extreme price (EP), the acceleration factor (AF), as well as the most recent PSAR. You will also need to determine whether there is currently an uptrend or a downtrend.

In simple terms, if the pair is trading under the PSAR you should sell. If the pair is trading above the PSAR you should buy. There are many ways to trade this indicator. You can trade it with additional indicators or on multiple/different time frames. Nathan Tucci wrote an article in May 2012 that illustrates how the PSAR can be incorporated into a trading strategy. See that article by clicking here and his Forex Trading System article by clicking here. You can also simply trade the Parabolic SAR for longer terms, trending pairs. For example, let me show you this EUR/USD daily chart:

The “extreme price” will either be the highest high or the lowest low that has occurred within the relevant period. Every time a new EP is established, the trend will be updated. The acceleration factor (which begins at 0.02) will increase by 0.02 for each of the first ten times that the EP has been updated (creating a functional AF “ceiling” of 0.20).

The Parabolic SAR (PSAR) calculation is:

  •         PSAR= Prior PSAR + Prior AF (Prior EP – Prior PSAR); for uptrends
  •         PSAR= Prior PSAR –Prior AF (Prior PSAR – Prior EP) for downtrends

The difference between the uptrend and downtrend formula is whether the second part of the formula is added or subtracted. It's important to note, without properly identifying the direction of the current trend, your PSAR calculations will be moving in the wrong direction.

Parabolic SAR Forex Rules for Short Trades

Rule #1-  Apply Parabolic SAR system and Moving Average indicators to chart

parabolic sar settings

You can choose different colors for the moving averages. The 20 period moving average is Red and the 40-period moving average is Green in this example.

Rule #2- The Parabolic SAR Indicator must change to be above price candle.

parabolic-sar-reversal

Notice how the dots were below the price. The parabolic stop and reversal (SAR) formula showed us that the price stalled out for a few hours and then the dot appeared above the candle.

This is a sign that a reversal may be forming.


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Rule #3- Another element that must occur is the moving averages must cross over.

In a short trade, the 20 period moving average will cross and go below the 40 periods moving average.

parabolic-sar-moving-average

So now the 20 period moving average is below the 40 period moving average. However, something occurred that is notable. The dot then appeared below the price candle.

Since the moving averages are telling us that a downtrend is most likely going to occur, we will wait until the dot appears again above price candle to validate this reversal and enter a trade.

Rule #4- Parabolic SAR dot must be above price candle AND moving averages cross to where 20 period MA is below 40 period MA.

moving-average-lines-cross

Note** One of these elements may occur before the other. The reversal dot can appear before the MA lines cross. Or the Moving averages can cross before the reversal candle. As long as there are both elements, the entry criteria are met.

Rule #5- Enter The Next Price Candle...

parabolic-sar-moving-average-cross

Enter (SELL) the very next price candle after the dot appears above the candle. You can see on our chart where we entered the trade. Waiting for one candle after makes sense because this proves to us that this reversal is strong. The moving averages are supporting the downtrend + the dot is signifying a downtrend.

Rule #6- Stop loss / Take Profit

The stop loss you will place 30-50 pips away from your entry.  Always look for prior resistance or support to determine a stop loss. In our example, a stop loss was placed 40 pips from entry.

short-entry-strategy

Your exit criteria are when the 20 and 40-period lines cross over again. OR when the dot reverses appears at the bottom of the candle.

This trade would have been a +203 pip profit using the MA cross exit approach. Not too bad.

Some will get out of the trade when the dot appears below the price candle. If that was the case, in this example, you would have got +32 pips instead. Still not bad, but +203 pips sounds a lot better.

So basically you can use either exit strategy. This trade the downtrend was very strong so we stayed in until the MA lines cross. Determine where you are in a trade. If you are up +100 pips and the dot changes to reversal consider getting out then and taking your profit.

Note** Scalpers should not be using a 30 to 50 pip stop with this strategy. Consider your rules and adjust accordingly. A 5-10 pip stop may be more appropriate on that low of a time frame. If you like this strategy and have a stop you think works best, leave us a comment below and tell us what you think!

Rules for Long Entry.

Rule #1-  Apply indicators to chart

Rule #2-  Dot must change to be below price candle. This is a sign that a reversal may be happening.

Rule #3- Another element that must occur is the moving averages must cross over.

In a long trade, the 40 period moving average will cross and go below the 20 period moving average.

Rule #4-  Dot must be below price candle AND moving averages cross to where 20 period MA is above 40 period MA.

Note** One of these elements may occur before the other. The reversal dot can appear before the MA lines cross. Or the Moving averages can cross before the reversal candle. As long as we have both elements the entry criteria is met.

Rule #5- Enter Next Price Candle. Enter the very next price candle after the dot appears below candle + MA lines cross and 20 period MA is above 40 period.

Rule #6- Stop loss / Take Profit

The stop loss you will place 30-50 pips away from your entry. Always look for prior resistance or support to determine a stop loss.

Your exit criteria in the example below were when the dot appeared above the candle.

parabolic-sar-long-entry-strategy

This would have been a nice +74 pip profit trade using this strategy.

Conclusion

As stated the Moving Average Trading Strategy can be used on any time frame. However, you should always check different time frames and look at what the market is currently doing. No strategy can give you a 100% win ratio so always be placing your stops at the appropriate areas.  I would recommend practicing making both short and long trades with this moving average trading strategy.

Thank you for reading!

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