Dynamic Stops with Parabolic SAR

07/21/2015 9:00 am EST

Focus: FOREX

Adam Lemon, of DailyForex.com, outlines another way for forex traders to use the Parabolic SAR Indicator beyond just trying to identify short- or long-term trend changes, but by using it as a form of dynamic stop loss to take a trader out of a trade with either a complete or partial exit.

One of the most popular forex indicators is the Parabolic SAR Indicator because it reflects when momentum is changing, and getting in early just as momentum changes can give you a winning edge. SAR stands for stop and reverse. There is, however, another way to use it beyond using the Parabolic SAR to try to identify trend changes, whether short-term or long-term: using the indicator as a form of dynamic stop loss to take you out of a trade with either a complete or partial exit.

What Is the Parabolic SAR?

The Parabolic Stop and Reverse formula was developed during the salad days of technical analysis in the 1970s, by Welles Wilder, who also designed the Relative Strength Index. As I explained last week, the Relative Strength Index is more or less the only forex indicator that can produce a winning edge on its own, so anything written by Welles Wilder is worth investigating.

The mathematical formula used to calculate the indicator’s value at each candle is algebraically complex, so I will try to explain it in extremely simplified conceptual terms, using a long example. When a candle makes a new high, the indicator sets a value below that candlestick. If candlesticks keep making new highs, the indicator’s value rises along with the price, but increases proportionately by a factor that the user selects (0.02 is the most common).

The idea is that time is the enemy and that the best part of any directional move to be in is the part where momentum keeps increasing. As such, this indicator is best used in trading trends or strong directional movements.

Wilder actually recommended using the Parabolic SAR indicator in conjunction with his ADX (Average Directional Index) indicator, which is also generally recognized to be one of the better and more useful forex indicators.

Parabolic SAR and Technical Analysis

The Parabolic SAR Indicator is a very simple binary indicator and is typically used in forecasting and trading strategies in the following ways:

  • Determining the trend. When a new candle opens and the indicator prints its dot on the other side of the candle from where it was on the previous candle, this signals a trend change and a trade entry possibility.
  • When determining the trend as outlined above, use the ADX indicator to determine whether the trend is sufficiently strong enough to justify a new trade entry in the direction of the trend.
  • When a number of candles have been making new highs or lows with the indicator’s dot consistently remaining above or below each candle, using the price of the dot (or something close to it) as a manually adjusted stop loss (i.e. a dynamic stop loss) to signal a trade exit.

NEXT PAGE: How to Get the Lift-off Required to Stay in the Game

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What is the Best Way to Use the Parabolic SAR?

I believe that the best use of the Parabolic SAR Indicator is as a trailing stop when trying to trade a strong directional move. I do not believe it has great value in determining when to enter: entering in the direction of the trend in forex is better determined by breakout or, usually even better, by moving average crosses / triple moving average signals.

Usually when trading strong directional moves, the best profit profile comes from trying to capture two different moves:

  • The initial short-term momentum move; and
  • The long-term directional move that is begun by 1.

Trying to capture only 1. is usually not very profitable in the long-term. A better strategy is to take partial profit when 1. ends, leaving the remainder to run in the hope that 2. will happen. Successfully capturing 1. can give you the lift-off required to be in the game at a good enough entry price to capture 2.

How to Use the Parabolic SAR as a Trailing Stop

One of the nicest things about this indicator is that it is extremely simple to use and does not really require any worry on the part of the user regarding the input values. The default values are fine.

One method is to simply manually adjust the stop loss price so that it sits a few pips just beyond the indicator dot as each new candlestick opens.

A second method is to wait for a candlestick to reverse and close beyond the dot. This will probably tend to produce better results over the long-term.

Remember that your own calculations about whatever strategy you are using should be brought into the picture. For example, if you ideally want to make a 50% trade exit at a reward to risk ratio of approximately 2:1, and you get a signal to exit at 0.5:1 which is way off that desired target, you might be better served by ignoring the exit signal, or perhaps, by moving the stop loss to break even.

Short Trade Example

A recent trade example is shown in the chart below of EUR/USD at the end of last week:

chart
Click to Enlarge

An initial trade entry could have been made at (1) following the very bearish reversal off the upper trend line. Note how a single candle later, the Parabolic SAR Indicator’s dots flipped from below the candles to above the candles.

Subsequently, using the dots as a trailing stop would have kept you in the short trade. Waiting for the candle to close would have prevented an exit at (2).

Once a partial exit is made, the remainder can be left to try to secure a really big move of a few hundred pips, as outlined in my previous explanations.

Warning: Only Use in Trending Markets

There are many ways to determine whether a market is trending, but the Parabolic SAR indicator does provide a good visual aid. If the chart shows the indicator dot flipping only occasionally and fairly long strings of consecutive candles with the dots all on the same side, then the market is “swinging” enough to give your trade a good chance of turning a profit. If the dots are not in series and are all mixed up, then it is a choppy market and probably best avoided.

By Adam Lemon, Contributor, DailyForex.com

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