Most traders apply the Parabolic SAR indicator in hopes of enjoying large profits but become trapped by losses whenever markets turn choppy. Although the Parabolic SAR can actually be an excellent trend-follower, it has one very important limitation: it is effective only under trending markets. Alone, especially in non-trending or “choppy” markets, the Parabolic SAR produces false signals, with even greater losses.
The Parabolic SAR is a strong tool developed by Welles Wilder to track trends; that is, the indicator can spot potential entry and exit points. It would “stop and reverse” for you, making it a very valuable tool when employed properly to take advantage of market movements with low risks.
To be profitable with the Parabolic SAR, one must use it in conjunction with a trend-confirmation indicator, such as the Average Directional Index (ADX). This will filter out weak trends so that the participant does not incur potential losses within choppy periods. The effectiveness of the Parabolic SAR will then be maximized.
Parabolic SAR Explanation
The Parabolic SAR indicator includes dots that appear above or below price bars on a chart; the direction of the trend is indicated:
- Dots Below Price Bars: This indicates an uptrend.
- Dots Above Price Bars: This indicates a downtrend.
This indicator is unique because it not only indicates the trend direction but also a stop-and-reversal signal for entry and exit. A buy will be indicated by dots switching from above to below the bars, and selling or exit will be when dots switch from below to above. The “stop and reverse” will allow the trader to ride with most of the trends at minimum risk.
Key Benefits of Parabolic SAR
Because it is easy to use and effective, the Parabolic SAR is especially useful in trending markets:
- Clear entry and exit signals: The indicator facilitates easy entry or exit on trades because of a shift in the trend.
- Minimal risk: A trader can set a stop-loss below or above an initial dot without exposing themselves to extreme risks.
- Ride with a trend: Parabolic SAR allows a trader to continue to ride a trend as long as it remains strong.
With that, the limitation of this indicator becomes evident in choppy markets, where it can generate a lot of “whipsaw” trades.
Problem With Using Parabolic SAR Alone
The best area for the Parabolic SAR to function is in areas of a clear uptrend or downtrend. It often gives false signals in choppy or sideways markets and creates various entry and exit points that aren’t likely to give lucrative results. This frustrates more traders than it makes them confident.
The problem is, markets tend to be sideways about 80% of the time and only trend 20% of the time. So, when you use the Parabolic SAR during the choppy periods, you will experience losses quite often since it is designed to follow a trend—not through a sideways market.
Parabolic SAR and ADX
Now, we must confirm that there is a trend in place before using the Parabolic SAR as a successful trading tool. For this purpose, we use the Average Directional Index (ADX). The ADX measures the strength of a trend and will determine whether the market is trending or not.
In this scenario, the ADX can be applied to validate the trend in question by avoiding dependence on the Parabolic SAR in a sideways market. This way, the possibility of false signals is diminished, and the indicator becomes more efficient overall.
Application of ADX with Parabolic SAR
Trend Validation
Normally, the ADX indicator has a threshold value, typically set to 20. If it is above 20, then it’s a sign of the presence of a trend. Below 20 means the market is either non-trending or weakly trending.
Entry Points
- Step 1: First, check if the ADX is above 20 to confirm that the market is trending. If the ADX is below 20, do not enter any trades with the Parabolic SAR because the likelihood of choppy movement is high.
- Step 2: Once the ADX confirms that there’s a trend, trace the signals of the Parabolic SAR to get into the trade.
Exit Points
The ADX does not provide specific exit points, so you still rely on the Parabolic SAR to exit. Once the dots change from below to above, or vice versa, then it’s time to close.
Example: Trading with Parabolic SAR and ADX
Assume that the ADX rises above the 20 level to indicate the start of a trend. Next, you will take the Parabolic SAR as a guide in finding the entry and exit points within this trend:
- Uptrend Entry: When the Parabolic SAR dots appear below the bars, this signals an upward trend. You will buy and place a stop-loss just below the first dot.
- Downtrend Entry: If the dots change from below to above the price bars, that indicates a downward trend and demands a sell position. Once again, a stop-loss can be placed just above the first dot.
Waiting for the ADX to affirm the trend can help you avoid choppy periods and result in more profitable trades when following the Parabolic SAR.
Optimal Timing of Entries for Better Risk-Reward Ratios
Although the ADX confirms the trend, it may delay entry points. Ideally, traders look to get into early trends to maximize the risk-reward ratio. Here’s how to time your entries effectively:
Using a Cycle Indicator
- Add a cycle indicator to identify the best time to enter and capitalize on what is likely to happen within the market.
- A cycle indicator will highlight optimal entry times to catch a trend before the ADX crosses the 20 mark.
Optimal Entry Bar Identification
Entering the trade earlier reduces risk since you can set your stops closer to the entry point. At the same time, riding a trend offers a large potential reward.
By combining the Parabolic SAR with the ADX and a timing indicator, a strong, reliable trend-trading strategy can be formed.
Indications of Avoiding Choppy Markets
Since choppy markets can easily lead to profit losses, staying disciplined is essential.
- Adhere to Threshold Levels for ADX: Only trade if the ADX reads above 20 to filter out sideways markets.
- Make Judicious Trading Decisions: Trend-following trades require patience. Do not enter trades if the market conditions are unfavorable, as this can help avoid several small losses that may occur during sideways markets.
- Tune Your System to the Market: If the market often appears choppy, consider blending in other strategies that are not trend-based, as the Parabolic SAR and ADX perform best in trending markets.
Conclusion on Making the Parabolic SAR Profitable
Combining a trend-confirming indicator like the ADX with the Parabolic SAR significantly increases traders’ success. It enables traders to enter trends with minimized losses in non-trending markets, allowing for effective timing and market condition-based usage.
In a nutshell:
- Ride the trend with Parabolic SAR to maximize profits with minimal risk.
- Confirm the trend with ADX to avoid choppy markets.
- Utilize cycle indicators to achieve the best risk-reward ratios.
The Parabolic SAR is a very robust and powerful indicator. Its profitability is fully realized when used within a strong strategy that accounts for changing market conditions. With discipline and patience, traders can exploit this indicator to the fullest and achieve their trading goals.
