How to Use Parabolic SAR to Buy Dips or Sell Spikes
Parabolic SAR is just another trend indicator offered by default by any trading platform and the overall idea when trading with this indicator is to make sure you end up on the right side of the market, or, simply put, to follow the trend. Even though it is considered to be a lagging indicator, traders found tremendous value when trading with it. As it is the case with all trend indicators, this one as well is used to find out places to trade in the direction of the general trend. It is not wise to use it to spot trend reversals as simply it is not built for this purpose. The Parabolic SAR was developed by the same guy that developed the worldwide famous Relative Strength Index (RSI), Welles Wilder. The SAR acronym stands for “stop and reverse”, but nevertheless, the indicator is a trend one. Having said that, it is applied to a chart and if the trend is a bullish one, one will see some “dots” below the actual price, indicating the price is going to move to the upside. The same is true on a bearish trend, only, this time, the dots will indicate a bearish trend. In other words, if a dot is placed above the price, this is considered to be a bearish signal, while a dot that appears below the price is a bullish signal. Buying and selling with the Parabolic SAR indicator is not that easy and straightforward, though, as you can see in the rest of this article.
To apply the Parabolic SAR to a chart, one needs to go and click the Insert tab on the MetaTrader 4 platform, then chose Indicators, Trend, and the Parabolic SAR appears.
After choosing the indicator, a popup window appears asking you to set the parameters for it: one can choose the color of it, the size of the dots that are to be applied, and even the period to be taken into consideration when applying the dots.
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Ways to Use the Parabolic SAR Trend Indicator
There are two main ways to use the Parabolic SAR indicator, and the most known one is to apply the indicator on a reasonable time frame (from the hourly time frame and above) and trade with a short-term horizon based on the overall trend. In other words, scalp your way for short profits based on the bigger trend direction. The other way to use this indicator is to time the exit from a trade that was profitable. It doesn’t matter what was the logic behind that trade, as long as it is in profit. Being a profitable one, the next question that comes to mind is when to exit the trade in such a way that the trend is not being missed. This is where the Parabolic SAR comes into play as it allows traders to trail their stops for profitable trades, therefore, to time the exit.
Buy Dips/Sell Spikes with the Parabolic SAR Indicator
Using the indicator under this approach implies a trend is already in place and traders are looking to find out places to trade in the general direction of the overall trend. This means usually scalping when markets are correcting the overall trend with the purpose of realizing some profits on a short period of time.
Identifying a trend can be made either using moving averages (like described in another article here at Forex Trading Academy, this can be done by using golden and death crosses) or simply using the very definition of a trend: a series of higher-lows/lower-highs that are not broken. The next thing to do is to apply the Parabolic SAR indicator on the chart in order to see the underlying main trend. The chart below shows the EURUSD four hours’ time frame with the Parabolic SAR indicator being applied.
It is obvious that the main trend is a bearish one, but this is not necessarily a conclusion offered by the Parabolic SAR. What traders are doing is to use it in order to trade in the same direction like the one of the general trend, but when the price is consolidating. In the example above, given the fact that the main trend is a bearish one, all we have to do is to look for shorting the pair for short-term to very-short-term profits. This is being called scalping. As mentioned at the start of the article, a dot plotted above price means a bearish environment and represents a bearish signal. Therefore, traders are looking to go short on the first bearish dot after a bullish signal, having in mind that the trade is short-term oriented. The chart above shows no more than six possible short trades if we count the one when the main bearish trend resumes and they represent a way to make a profit when the market is in a range.
Use the Parabolic SAR to Trail Stops
Exiting a trade is as important as entering one as many times traders are exiting a trade only to find out that price starts moving even more aggressively in the right direction. One way to avoid this is to trail your stops with the Parabolic SAR indicator. To do that, it is assumed that already there is a trade that is well into profits. This trade may have been taken considering some other indicators or trading theories and now the question is when to exit it. For that, the Parabolic SAR is applied on a lower time frame, ideally not lower than the hourly chart. If the trade is a long one, so the trend is a bullish one, the Parabolic SAR indicator will show the dots below the price. The idea behind trailing the stop is to raise it with each and every dot that is rising as well, as this means the overall price is still moving to the upside. By the time the dots are moving above price, is a signal that the trade should be closed. This way, the risk of a sudden trend reversal is overcome and if the Parabolic SAR dots are moving above the price it means the overall trend might end so it is safe to exit the trade. Even though it is considered to be a trend indicator, the Parabolic SAR is mainly used in addition to a trending environment. This doesn’t change the fact that it represents a valuable tool for profitable trading.
Other educational materials
- Three Ways to Trade Forex with CCI (Commodity Channel Index)
- Overbought and Oversold Areas in Ranging Markets
- Profit from DeMarker Divergences
- Forex Trading Accounts and the Value of a Pip
- The Importance of Swap and Spreads
- How to Enter/Exit a Trade
Recommended further readings
- Getting Started in Chart Patterns. Bulkowski TN. John Wiley & Sons; 2006 Feb 1.
- Persistence, Performance and Prices in Foreign Exchange Markets. Ramadorai, T. (2006).