How to trade with Parabolic SAR indicator
Although the indicator looks simple there are a few important tricks to using it.
One of the best uses described by it inventor J Welles Wilder is for placing stop losses and where to exit a position. Once the dot appears above the price a short position would be entered and a stop loss can be placed at the location of the dot. The stop loss is then adjusted to each new dot and as the trend continues you keep adjusting downwards.
If the price jumps back through the dot the stop loss is triggered and if the dot, then appears below the price the trade is also closed.
The developer of this indicator did not expect it to be used by itself as there are a few complications with a see-saw effect where the dot jumps repeatedly creating false signals during consolidation periods. The indicator works best during trending markets so using it in conjunction with another indicator that spots trending markets is essential.
Wilder himself developed the ADX indicator that can be used as it helps to determine the strength of the trend. Trades would then only be entered once the ADX reading is high enough to confirm a strong trend. Other indicators such as moving averages can also be used to determine the direction and strength of the trend.
One of the reasons for its effectiveness in setting stop losses is an acceleration factor that is built into it. When a trend starts the dots are close together but as the price movement gathers speed the indicator adjusts the dots wider apart so that the stop loss is never left too far behind.
The two variable settings are the step and the max step. The recommended settings from Wilder are a step of 0.02 and a max step of 0.2. If the step is too high the indicator will become more sensitive but this can lead to an increase in the see-saw effect and if it is too low the indicator will become smoother.
The max step is used to set a maximum stop loss distance. The higher the max step the tighter the dots will appear to the price.
What to look out for
If the gaps between the dots have already started to increase, a trader may look to avoid entries in the direction of the trend as it might be too late.
When looking at the entry and exit points other factors can be included such as support and resistance levels and whole numbers.
The Parabolic SAR indicator is used to identify trends, where they may be reversing and their direction. It is one of the easiest to understand from a simple glance. Parabolic SAR consists of a set of dotted lines, where each dot is one period.
When the dots are below the price, traders should be long. Once the dots appear above the price you would look to go short
This indicator allows you to be in the market constantly reversing your position each time the dots cross the price line.