Using Technical Analysis to Approach the Forex Market: Technical Indicators V (Parabolic Stop and Reverse)

By Bob1000pipbuilder | Aug 06, 2020 Using Technical Analysis to Approach the Forex Market:  Technical Indicators V (Parabolic Stop and Reverse)

So far, we have explained the trend technical indicators, Moving Average Convergence Divergence (MACD), Moving Averages, Bollinger Bands, Ichimoku Kinko Hyo, and Relative Strength Index (RSI). By now, you have learned how to use those indicators for any or all of their commonly-cited purposes: to determine market trends, potential reversals, and also to find out the best times to buy and to sell, irrespective of the particular financial asset being traded.

Trading trends is a simple, yet exciting way to participate in the Forex (or any other financial) market. “The trend is your friend” is a popular and effective trading precept. So, what could be a better precept to follow than it? When you trade in the direction of the trend, you trade in the direction of least resistance. As a result, with ease, you can ride on the particular direction in which the market is headed and capture some profitable moves along the way.

One more technical indicator that enables you to do that is the Parabolic Stop and Reverse (Parabolic SAR). And here, we will be talking about it. This indicator was devised by J. Welles Wilder, Jr., the same man who developed other trend indicators such as the Relative Strength Index (RSI), Average True Range, and Average Directional Index. He is noted to have developed more accurate trading systems than any other trading expert! Parabolic SAR works on a system of parabolas to detect a wide range of market conditions to which it can be applied.

Importantly, however, you should note that the Parabolic SAR works specifically only under trending market conditions. In fact, when the market is ranging or consolidating, it instead tends to give “whipsaws.” These “whipsaws” are choppy market conditions that tend to be characterised by either fake signals or unclear ones. As a result, if you will be trading with the indicator, it is advised that you identify a definite, prevailing trend first before you do.

Parabolic SAR
The Parabolic SAR is a trend technical indicator that is invaluable in determining the direction of financial assets and points at which they can potentially either stop or reverse. This is exactly why the indicator is also known as the “stop and reversal system.” It is represented by sets of dots that are bundled together to form parabolas and are formed either above or below the price charts. The position of the parabolas in relation to the price determines its behaviour and helps to dictate the specific trading action to take.

For example, when the series of dots exists below the price, the market is said to be exhibiting a bullish signal. Conversely, when the series of dots (or the parabola) is above the price, the market is usually believed to be bearish or possibly set to be plunged into the downward direction. However, because it is considered a lagging indicator, the Parabolic SAR works best when used with other indicators or additional tools.

How to Use Parabolic SAR
So, how do you use the Parabolic SAR? The indicator, first of all, you must note, is very easy to use. Also, the signals it generates are often very clear and straightforward to apply. To successfully use it, the important thing to do is just to look out for the behavior of the parabola in relation to the price. Overall, in this regard, the following steps will guide you:

Step 1: Focus on the SAR dots. For a buy signal, wait for them to switch from above the price to below it. To guard against false signals, before you enter a position, wait for all for the signals to close.

To use the Parabolic SAR to buy, first wait for the indicator’s dots to form below the price. This shows that an upward market move is about to be initiated.

Step 2: Use each SAR to set trailing stops. That is, following each parabolic action, you can continue to move stop losses down in profit.

Step 3: The Parabolic SAR indicates trend reversals with the dots’ flipping on the opposite side of the price. Thus, a sell trade is triggered when the dots switch from below the price to above it.

Step 4: To fight off fake signals, always wait for the appearance of trend lines or use the indicator with other indicators before you make a trade. Also, avoid the use of Parabolic SAR in choppy market conditions.

For a sell trade, wait for the indicator to form above the price. This indicates that the market is about to move down.

Parabolic SAR does not just give buy or sell signals. Additionally, it suggests prices at which trailing stop-loss orders and different profit targets can be set and those at which the market can potentially reverse. Overall, the indicator helps traders to capture, as many as possible, opportunities that come with trends. This is why, to avoid all the shortcomings associated with its use, you must first confirm the market’s definite trend before you use it.

Parabolic SAR is an effective trend technical indicator. It is especially highly useful for the identification of potential market reversals and the determination of entry and exit points. All these it does by analysing the tendency of price to remain within parabolic curves during strongly trending market conditions. This you can also discern yourself by looking out for the position of the parabola in relation to the price.

For example, the price tends to be bullish when the parabola is below it. This parabola, as a result, can be used as the support. On the other hand, when the parabola is above it, the price is most likely bearish. This kind of parabola, the parabola above the price, is used as a level of resistance. Furthermore, both parabolas can be used for setting important money management levels such as profit target and stop loss.

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