Parabolic SAR: What is it and how do we use it?

The Parabolic SAR is an indicator based on price and time designed to closely follow trends and literally “Stop And Reverse” when they have ended. The dot is drawn as the stop and reverse (SAR) point which is below the price in a downtrend and above the price in an uptrend. Once price hits the stop point, the system would close the existing position and reverse direction with the opposite trade.

Forex_Strategy_Corner_Using_Parabolic_SAR_as_Trading_Strategy_body_Picture_5.png, Forex Strategy Corner: Using Parabolic SAR as Trading Strategy

Acceleration Factor (AF) determines the rate at which the SAR point will converge to current price action. The higher the AF, the more quickly the SAR will converge with price during a trend.

Extreme Point (EP)is the highest high during an uptrend or the lowest low during a downtrend.

The calculation for the Parabolic SAR is such that the “Stop and Reverse” point moves progressively higher and closer to the actual price low as a trend continues. This intuitively makes sense: the longer the trend the more likely it is to reverse. When that reverse occurs, you would want your hypothetical “Stop and Reverse” point as close to current price as possible.

We can vary the speed at which the SAR converges with price via the AF. With each step that price moves to a higher high or a lower low, the SAR point will move closer to a rate directly proportional to the AF. The default value for the AF on most charting packages and in literature is 0.02, while the maximum AF is most often capped at 0.20.

Sample trading rules using the Parabolic SAR are subsequently rather simple: go long when the stop and reverse point is below current price and go short when it is above. Thus we have a simple system to test, and hypothetical performance is easy to calculate using automated trading software.

Forex Parabolic SAR Trading Strategy

Entry Rule:When the Parabolic stop and reverse point is below current price, go long. If price subsequently touches the stop point, close the long position and go short on the open of the next bar.

Stop Loss:Stop and reversal point is the stop loss and point at which the strategy flips direction.

Take Profit: None

Exit Rule:When price hits the stop and reversal point, close the trade at the open of the next bar and flip direction.

Backtesting our Forex Bollinger Band Reversal Strategy

Using FXCM’s Strategy Trader software, we will code a strategy based on this popular technical indicator and see the results. In doing so, we can easily test our concepts across the spectrum of currencies and time frames.

View a video guide on strategy backtesting and optimization in Strategy Trader here:

http://forexforums.dailyfx.com/strategy-trader-webinars/220697-basic-backtesting-optimization.html

Download and install the Strategy Trader platform, then import the following code example from the DailyFX forex forum. Download the attached .zip file. Go to the directory under which you've unzipped the contents of the file. Open the "ParabolicSAR.fxd" file and when prompted by the Strategy Language Editor, hit "OK" to import the file. Once you have imported the Strategy Advisor, open the "ParabolicSAR.fxw" file included in the attached zip to see examples on how you may use this in your charts.

Forex Parabolic SAR Trading Strategy

We ran this strategy on the EURUSD, USDJPY, GBPUSD, and GBPJPY across four different time frames. We assume transaction costs of 3 pips on the EURUSD, USDJPY, and GBPUSD and 5 pips on the GBPJPY per round-trip trade. Below are the hypothetical equity curves of said strategy run across four different time frames.

Forex_Strategy_Corner_Using_Parabolic_SAR_as_Trading_Strategy_body_Picture_6.png, Forex Strategy Corner: Using Parabolic SAR as Trading Strategy

Though past performance is no guarantee of future returns, the strategy shows promise in trading these select currency pairs. Yet the breakdown between timeframes is telling.

On the low-frequency end, the strategy does not seem to fare particularly well on a weekly chart. It seems as though the Parabolic SAR has historically been too slow in picking up on shifting trends in these four currencies over the past 8 or so years of trading.

On the high-frequency end, the Parabolic SAR is far more nimble yet nonetheless does poorly across these four currency pairs through the selected time period. Yet the reason for said underperformance has less to do with the indicator itself and more to a common failing of many high-frequency strategies: transaction costs.

For EURUSD pair alone, this strategy theoretically generated a whopping 4481 trades over the testing period. On round-trip spreads, this would have amounted to nearly $15,000 over the course of 8 years based on our spread assumptions. Without that extra transaction cost, the strategy would have theoretically generated a profit on the currency pair.

The Parabolic SAR indicator seems to find its best results somewhere in between the low-frequency and

high-frequency extremes. If we take a look at the results on 240-minute and 1-Day charts, the strategy has hypothetically done relatively well over the years. This is especially true during times of strong and extended price trends. Like many trend-based indicators, the Parabolic SAR can get chopped out during range-bound price action.

Applying Our Analysis to Existing Strategies/Trading Styles

Hypothetical backtests show that our benchmark Parabolic SAR strategy has performed relatively well on several major currency pairs over the past 8 years of trading. Given that SAR can likewise be used as a method to set trailing stops for many trend trades, we can see how this could apply to our own trading.

We encourage you to download the strategy and run different combinations of said systems on currency pairs and time frames. Strategy Trader will likewise allow you to run multiple strategies on the same chart—particularly useful in gauging the historical effectiveness of Parabolic SAR in setting stops for existing trading techniques.

If you would like to suggest ideas for this topic or any other forex strategy you would like to see in this series, feel free to e-mail author David Rodríguez at drodriguez@dailyfx.com.To be added to this author’s distribution list, e-mail with subject line “distribution list”

View previous articles in this series:

Using Seasonality Strategies in Your Trading

Forex Trading Strategy Analysis: Trade with Market Conditions

How do we use Money Management for Moving Average Forex Strategies?

How do we set stops for the Range Trading Strategies?

Using Candlestick Formations in Forex Trading

Written by David Rodríguez, Quantitative Strategist for DailyFX.com