The Parabolic SAR(or PSAR for short) is a very unique indicator that is dynamic and has a multitude of uses.
The unique feature of the PSAR, is that it takes into account “time decay”. The idea is that a position needs to keep paying profits in order for us to keep the position.
Created by J. Welles Wilder, Jr., and published in his academic paper back in 1978.
In case the name sounds familiar, he was also the creator of the famous RSI indicator.
Now the PSAR is generally a trend indicator, with the initial objective to identify starts or ends of trends.
You’ll find that PSAR follows price with a series of dots on the chart.
In an uptrend, the PSAR dots are below price, vice versa, in a downtrend, the PSAR dots are below price.
When price breaks the dot, it means the trend is slowing down and could be reversing.
The PSAR dot then immediately flips to the other side of price.
But it cannot be used on its own as a complete trading strategy.
The whipsaws experienced by the PSAR during range periods are epic.
Therefore, it is highly recommended to use this in conjunction with a trend filter of some sort. Popular choices include the MACD, ADX or just moving averages.
However, to be a purely systematic system, the strategy requires a bit more rules.
I’m going to test an idea which can be the base to develop a full PSAR strategy system.
I will be exploring a multiple time frame approach by using PSAR on a longer time frame for trend context, and PSAR on a shorter time frame to time our entries with the broader trend.
I’ve decided to keep with the original parameters of 0.02 step at 0.2 maximum acceleration.
If you want it to be more reactive to markets with large magnitudes, you can increase the step or acceleration.
To keep things simple, exits will be scaled out at 1:1 risk reward or SL.
After scaling out at 1:1, we use the Daily PSAR as a trailing stop loss to exit our trade.
Initial stop losses are below prior swing highs/lows.
We can have 1 position at any point in time. This means we are only Long or Short, never both at the same time.
In a trend everything tends to work well, so I’m more keen to see if the filter helps us minimize losses during the more range bound periods.
So I’ve chosen this recent period on the daily chart of the S&P500 that has been in a range.
You can see that in this range period on the Daily chart, trading every PSAR signal will get you painfully whipsawed.
Although still marginally profitable, with a hit rate of 40% and 57 points as you can see on the stats.
Now let’s try adding our higher time frame filter.
We will use the PSAR on the Weekly chart to guide our trades on the Daily.
So if price is trading ABOVE the Weekly PSAR, we only look for Longs on the Daily PSAR.
Vice versa, if price is trading BELOW the Weekly PSAR, we only look for SHORTS on the Daily PSAR.
These are the results below:
So you can see, using this higher timeframe filter does indeed help tremendously in the recent range environment.
We now have a 64.3% hit rate and net profits of 616 points!
I hope this has given you a better understanding of how the Parabolic SAR indicator works and how you can apply it in your trading.
Have fun with it and maybe you will find a role to play in your system.
Good trading everyone!