Parabolic SAR or parabolic Stop and Reverse is one of the most visual technical indicator. The rising dots below the price action which move up when the price is moving up and hence indicating uptrend. The falling dots above the price action and moving down with the price when the price is falling and hence indicating a downtrend. When trend reverses and when the rising or falling dots hit the price action then it's the time to stop the trade and take a position in the opposite direction. Stop and Reverse.
But is it really so simple?
The answer is "No". Parabolic SAR does not indicate the trend and hence we can not take buy positions when the dots are below the price action or vice versa.
Then how to use parabolic SAR?
Well, As the name suggests, The Parabolic SAR helps us in the following:
1) Putting the trailing stop-loss orders.
2) Exiting the trade when the SAR indicates that its time to stop and reverse the direction.
But well, as we mentioned above that both of the above statements are not as simple as they seem and hence before getting a better feel of the above points let's see when the Parabolic SAR indicator works and when it should be neglected.
Rule #1: Parabolic SAR works better in trends but should be neglected when price is having a sideways movement.
So how do we ensure the application of rule #1?
Well, the rule #1 can be applied by confirming whether it is a trend or not.
Confirmation of the trend:
Whether there is a clear trend or not can be ascertained one or a combination of the flowing:
1) ADX: ADX should be above 25 and rising.
2) MACD: For uptrend a bullish MACD i.e. MACD line crossing over the signal line. For downtrend the MACD crossing below the signal line.
2) Slow or Full Stochastic: Bullish Stochastic i.e. stochastic line crossing over the signal line for uptrend and bearish stochastic i.e. the stochastic line crossing below the signal line.
Now once we have confirmed that there is a trend in a particular direction, we are comparatively safer to use SAR as follows:
1) Putting the trailing stop-loss orders:
If the dots are emerging below the price action and we have a long position then we can move our stop-loss levels up at the level of rising dots. We can simultaneously raise our take profit targets. We should do this by keeping an eye on the other indicators mentioned above for reconfirmation that the trend is keeping up. The same is true with short positions. We continuously move our stop-loss levels to the level of dots moving down with the price. We can also move our take-profit levels further down if other indicators are showing that the trend not slowing down.
2) Exiting the trade when the SAR indicates that its time to stop and reverse the direction:
let's say that we have a long (buy) position during an uptrend. The SAR dots appearing below the price actions are also moving up. This movement is initially slow but becomes faster with time and the dots come closer to the price action. There is some correction and price moves down. The moment the moving up dots hit the moving down price, SAR indicates that it may be safer to close down the position as the price may go further down. We can close our long position and open a short position. BUT WAIT. Confirm the downward trend with the above mentioned indicators and if they are not confirming a developing downtrend then please do not open a short position. So Stop and don't reverse.
The same is true with short positions during downtrend. The price is falling down and the dots are over the price action and moving down. When price reverses the direction and falling dots hit it, it indicates taking profits by closing the position.