The parabolic SAR is a technical indicator used to determine the price direction of an asset, as well as draw attention to when the price direction is changing. Sometimes known as the “stop and reversal system,” the parabolic SAR was developed by J. Welles Wilder Jr., creator of the relative strength index (RSI). The parabolic SAR is one of the easiest indicators out there to use, however, the settings play apart in its usage, and it will be the factor that determines whether or not this indicator is profitable on its own. With the default settings in place, it is a lagging indicator that response late to the change in market prices. Conversely, it is still able to capture the turning points of trends such as pullbacks and even the start of reversals. The tricky part of using this indicator however, will be differentiating the former from the latter even when the parabolic SAR is supposedly one of the easiest indicators out there to use. The main objective of this article will be to find out if the parabolic SAR, being easy to use, would be tantamount to being profitable as well.
Parabolic Sar – Quick Setup Tutorial
How to use sar
The parabolic SAR is pretty straightforward to understand and pick up. When prices are predicted to be bullish, the parabolic SAR will display a dot at the bottom of the candle. Subsequently, when prices are predicted to be bearish, the parabolic SAR will display a dot at the top of the candle. The indicator predicts a bullish or bearish direction of the price based on the momentum of the price. If the bulls far outweigh the bears, the momentum of prices would change and hence would the direction of the prediction. This might sometimes give rise to conflicting signals in the market. The distance between the dots and the candles shows the strength of the price momentum. The further away the dot is from the price, the higher the probability that prices will continue to trend in the predicted direction. Conversely, when the proximity between the dot and the candle is near, the momentum of the trend is said to be dying down and a directional change is soon to be expected. The parabolic SAR can also be used as a stoploss determining indicator. The dots of the parabolic SAR can be taken as a safe stop loss level even though it would meant that the stop loss would be often excessively huge.
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To minimise the probability of the parabolic SAR from giving us conflicting signals, we have decided to take trades only when the parabolic SAR shows consistency in its prediction. To do so, we will only take trades after the dots of the parabolic SAR shows the same signals across 3 candles of market data. To simplify it, trades will be taken on the 4th candle, provided that the dots are aligned in providing one signal. For long trades, entry will be placed via a pending order on the high of the candle at the 4th dot of the parabolic SAR in a trend. The stop loss will be taken slightly below the dot of the parabolic SAR. Lastly, the take profit will be at the first contradicting signal provided by the indicator, in this case, a dot on the top of the candle after it closes.
As for short trades, entry will be placed via a pending order on the low of the candle at the 4th dot of the parabolic SAR in a trend. The stop loss will be taken slightly above the dot of the indicator. The take profit will be at the first contradicting signal of the parabolic SAR, a dot below the candle after it fully closes.
Pros and cons
The pro of using the parabolic SAR is that it is able to identify the trend and also measure the strength of the trend or the change in the direction via the proximity between the dot and the candle. Besides, it is able to point out signs of directional change be it a pull back or a reversal. Also it acts as a stop loss providing indicator creating a safe level to avoid getting stopped out. However, it is vulnerable to giving contradicting signals when market is in a consolidation phase. Experience is often required to distinguish a pullback from a reversal as well when market is trending. Though it is able to provide information on the momentum to a certain extent, it is lacking as it is unable to provide information regarding the volume of the market. Lastly, even as it is able to provide a stoploss and take profit level, it is unable to give a clear entry level. As such this renders it to be heavily reliant on price action for entry signals.
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To find out the profitability of the Parabolic SAR trading strategy, we decided to do a back test based on the past 10 trades from 9 Jun 21 on the H4 timeframe. The rules for entry will be the same as what was mentioned above. We will be back testing this throughout 3 types of trading vehicles, namely, EURUSD for forex, AAPL for stocks and BTCUSD for cryptocurrency. For simplicity, we will assume that all trades taken have a risk of 1% of the account.
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Definitions: Avg Risk reward ratio= ( Total risk reward ratio of winning trades/ total no. of wins) Profitability (% gain)= (no. of wins* reward)- (no of losses* 1) [ Risk is 1%]
An example of the application of the strategy is as shown:
For the Backtest results, trades with blue and yellow zones indicate an overall win with the blue zone as reward and the yellow zone as the risk taken.
As shown in our backtest, the win rate of this strategy for EURUSD (Forex) is 50%, AAPL (Stocks) is 40% and BTC (Crypto) is 30%
The average risk reward ratio of this strategy for EURUSD (Forex) is 0.522, AAPL (Stocks) is 0.909 and BTC (Crypto) is 1.38.
The profitability of this strategy for EURUSD (Forex) is -4.61, AAPL (Stocks) is -3.64 and BTC (Crypto) is -3.14.
In conclusion, the parabolic SAR is highly not recommended to be used solely on its own. Though it is able to provide some wins, the risk to reward ratio in trades are too poor as the stop loss is more often excessive. Although it is simple to understand and use, it is definitely not a beginner friendly indicator as it would take an experienced trader to distinguish a pull back from a reversal when the parabolic SAR gives a contradicting signal. This would result in a series of premature exits, leaving partial losses or small wins in the trading record of beginners. Not to mention that it is still a lagging indicator, giving rise to a higher percentage of partial losses than partial wins. However, it can still act as a good support indicator to identify strength of pullbacks and trends when used with other indicators.