The Parabolic SAR (i.e. stop and reverse) indicator is a trend seeking indicator which is used to detect when a trend stops and reverses. Therefore, it detects the stopping of an uptrend and a reversal of the price to a downtrend, and vice versa. On a chart, the Parabolic SAR is marked by dots which appear under the candlesticks when the downtrend stops and reverses to an uptrend, and appear under the candles when the uptrend stops and reverses to a downtrend.

If you look closely at the workings of the Parabolic SAR, it will be very obvious that this indicator has a lot of lag. Usually, the price would have been on its way by the time the signal appears, so a trader who relies only on the Parabolic SAR for trade signals will only be able to enter trades very late indeed, and will only pick a few pips, if any at all. Therefore, the trader must combine the Parabolic SAR with other indicators or trade signals to be able to catch the reversal moves early. In this article, we will show you two cracking ways that the Parabolic SAR can be used to pick out profitable trading signals.

Strategy 1: Using the Parabolic SAR with the MACD and the 200 SMA

This strategy which is used on the 4 hour chart, uses the following indicators:

a) 200 Simple Moving Average, which helps the trader to detect the ongoing trend. If the price action is below the 200 SMA, then this is a sign that the currency pair is in a long term downtrend. If the price action is above the 200 SMA, then the currency pair is in a long term uptrend. It is important to know this as this will eventually help you determine which Parabolic SAR is valid and which should be ignored.

b) The 13 Simple Moving Average, which is the short term moving average that will serve as a support (for a long trade setup) or resistance (for a short trade setup). A bounce of retreat of the price on this moving average is significant for trade entry as we will demonstrate shortly.

c) Forexoma-MACD Histogram, which is a custom forex indicator that was developed by Forexoma Corporation. Unlike the traditional MACD, the Forexoma-MACD is colour-coded and once the trend of an asset changes, the colour of the bars of the MACD changes as well, enabling traders to detect trend changes earlier instead of waiting for the traditional cross above or below the zero line.

d) Parabolic SAR, applied to the chart with its default settings.

Short Trade Setup

For a short trade, we will be looking for the following setup:

a) Price located below the 200 SMA. This is the first parameter. Therefore the bias for the trade should be to go short. If the 200 SMA is below the price but the 13SMA described below is above the price, then the 200 SMA can be used as a support line for trade exit. The 200 SMA can indeed act as a support or resistance if the price action is close enough. For the short trade, we are looking for the price of the currency pair to be below the 200 SMA, or for any upside correction to hit and retreat from the 200 SMA.

b) Any upside move that butts off the 13 Simple Moving Average, and this occurs at almost the same time as:

c) Parabolic SAR indicator appearing above the price action AND

d) Forexoma-MACD changes from blue to red, or has already changed to red colour.

Once these signals all align, then enter short at the open of the candle following the signal. We see a perfect example below:

In this example, we see the grey vertical grid line which we have drawn in order to show that the signals occurred at about the same time. So we see the Forexoma-MACD colour indicator change colour from blue to red, and the price action bouncer off in a downward motion from the 200 SMA and the 13 SMA, which both act as very strong resistance factors. This downward move was good for a massive 350 pips, which serves to show why the 4hour chart is such a brilliant chart for this trade setup.

Stop Loss: This should be set at a 5 pips below the first dot of the Parabolic SAR.

Profit Target: Use the change in the signal of the Parabolic SAR (i.e. appearing BELOW the price action) as the trade exit signal.

Long Trade Setup

We move ahead to just 4 days after the short trade setup above, to see how a long trade setup plays out. Remember, this is a stop and reverse strategy, so the end of the short trade above could signal the long trade setup if the parameters are correctly aligned.

We will be looking out for the following:

a) Price located below the 200 SMA. If the 200 SMA is located above the price action, then it should be used as a resistance level, suitable for trade exit. This condition only holds if the 13 SMA is located below the price action.

b) Candlesticks that bounce upward off the 13 Simple Moving Average, and this occurs at almost the same time as:

c) Parabolic SAR indicator appearing below the price action AND

d) Forexoma-MACD changes from red to blue, or has already changed to blue colour.

Look at the chart below:

Once more, we have our grey vertical grid line for referencing where the parameters line up. We can see that the MACD histogram has already changed colour to blue, so we look for where the candlesticks bounce up from the 13 SMA at the same time that the Parabolic SAR is below the price action. This is shown at the area circled with green ink. The long trade should then be opened at the open of the next candle. The trade shown above was good for at least 300 pips.

Stop Loss: This should be set at a 5 pips below the first dot of the Parabolic SAR.

Profit Target: You can use the 200 SMA as the exit point. Otherwise, the change in signal of the Parabolic SAR (i.e. appearing above the price action) can be used as the trade exit signal.

This is one of the two ways that the Parabolic SAR can be used with good results, securing many profitable trades in the process.

Strategy 2: Using the Parabolic SAR with the ATR, Simple Moving Averages and Multiple Time Frames

How interesting does this get? Now we want to show how to use the Parabolic SAR with multiple time frames so that you avoid the trap of getting signals when indeed the market is going to end up being flat for quite some time.

When the market is trending, then you can really make some good money with the Parabolic SAR. You simply trade with the corresponding stop and reverse signals. But when you run into a consolidating market, then things can get very ugly. You do not want to get a Parabolic SAR trade signal when the market is flat. Not only will you make no money, but indeed the risk of losing money can be very real. This strategy helps you avoid that by using the Average True Range (ATR) indicator which we discussed last week, and multiple time frames (15 minutes, one hour and 4 hour charts).

The strategy starts with attaching the simple moving averages to the chart. The simple moving averages are your key tools that tell you if the market is trending or flat. The moving averages to use are:

a) 8 Simple Moving Average

b) 21 Simple Moving Average

Ideally, the shorter term moving average (i.e. the 8 SMA) must have crossed the 21 SMA, and both must have been pointing to a particular direction. These are what will point to the trend of the asset. So they should be pointing upwards or downwards. If they are pointing sideways, then the market is going to be flat and you should stay away from the market.

Next, the Parabolic SAR indicator is added to the charts and left in its default settings (though you can change the color if you wish).

The ATR indicator is also added to the mix in its default settings. All these indicators are available on Forex4yous MT4 trading platform and can be added using the Indicator tab or the Insert button at the top of the page.

Long Entry Rules

Ensure that the candlesticks (representing the price action) are above the 8 SMA and that the 8 SMA is above the 21 SMA. Both simple moving averages must be heading upwards, indicating an uptrend, and we want to trade with the trend because it is our friend. These scenarios must occur on the 15 minute, one hour and 4 hour charts simultaneously.

At the same time, the values of the Average True Range must be close to the upper limit of the range, signifying that the market will have enough volatility to perform according to the trades expectation. If the ATR were to be at the baseline, or at the lower end of the spectrum, this would negate the trade signal.

The entry should be made on the 15 minute chart, at the candle where the Parabolic SAR has appeared below the candlesticks, signifying a bullish signal. For better entry, you can wait to see if the price action will try to move down below the 8 SMA. Usually, it will be resisted at that level and start to move up. So you get the opportunity to take the trade from the true starting point, garner more pips and make money.

Stop Loss: This is set at the price level that corresponds to the first dot of the Parabolic SAR as the starting point. As a new dot of the Parabolic SAR appears below the candles but at a higher level, the stop loss is manually adjusted to the new levels. You continue to adjust the stop loss upwards (effectively locking in the profits as you move along) until the trade reaches its logical conclusion.

Profit Target: Profits are taken either by closing the trade manually when the Parabolic SAR appears above the price action, or when the moving averages start to turn sideways. This means that the trader has to watch the trade from start to finish; it is not a set and forget trade strategy.

Short Entry Rules

Simply reverse what is done for the long trade. Make sure that the price action is below the 8 SMA and that the 8 SMA is also below the 21 SMA. Both the 8 SMA and 21 SMA must be pointing downwards, signifying a downtrending price action, and this situation must be found on the 15 minute, one hour and 4 hour charts simultaneously.

At the same time, the values of the Average True Range must be close to the lower limit of the range.

The entry should be made on the 15 minute chart, at the candle where the Parabolic SAR has appeared below the candlesticks, signifying a bullish signal. For better entry, you can wait to see if the price action will try to move down below the 8 SMA. Usually, it will be resisted at that level and start to move up. So you get the opportunity to take the trade from the true starting point, garner more pips and make money.

Stop Loss: Set the stop loss at the price level that corresponds to the first dot of the Parabolic SAR, and keep adjusting it as the new dots of the Parabolic SAR appear above the candles but at a lower level, effectively locking in your profits as the trade progresses to its logical end.

Profit Target: Closing the trade manually when the Parabolic SAR appears below the candlesticks, or when the moving averages start to turn sideways are the two ways to take profits from a short trade entry.

See a typical BULLISH setup below:

15 MINUTE CHART

Notice how the signals all tally with each other, allowing the opportunity to take the trade on the 15 minute chart. Practice how to detect a short trade setup as your assignment following this article.

Strategy 1 is a long term trading strategy while Strategy 2 is a short term trading strategy. If you have been mystified by the Parabolic SAR, this article should clear up the cobwebs.