Analyzing crypto markets using technical analysis is indeed the most preferred method for speculating on crypto prices. Among the several subdomains in technical analysis, technical indicators are a highly rated tool. With the advent of computer algorithms, analyzing past prices in different ways has become an efficient way for short-term traders to leverage their market analysis.
With various technical indicators in the market, the Parabolic SAR indicator is one of the most preferred by technical analysts. The calculation and derivation of the indicator are unique and powerful, making it a reliable trading indicator to speculate the price movement. Parabolic SAR also works well with price action and other indicators for a more solid trade signal.
This guide will dive into understanding the Parabolic SAR indicator and discuss some compelling trading strategies using this technical tool.
What Is the Parabolic Stop and Reverse Indicator?
The Parabolic SAR indicator is a technical indicator that helps predict upcoming market reversals and the possibility of current trend continuations.
Parabolic SAR works by helping traders forecast both bearish and bullish reversals and helps analysts gauge if markets continue in the same predominant direction. In addition, the indicator can help traders time their signals and steer away from false signals to know when exactly to go long or short.
Certain features of the Parabolic SAR make it an all-around indicator. Interestingly, it was created and first applied by the same analyst who created the Relative Strength Index (RSI) oscillator, J. Welles Wilder Jr. Parabolic SAR is also known for its versatility since it works for most markets (including cryptocurrency) and within various time frames.
Years ago, the indicator was embedded in the PSAR strategy as the Parabolic Time/Price System. The abbreviation SAR meant the points at which traders must enter with long positions and exit trades with short positions and vice versa. It is currently known as the Parabolic SAR indicator, providing buy and sell entry points and forecasts on trend continuation, market reversals, and even breakouts.
Calculating the Parabolic SAR Indicator
With recent technological advances, the indicator is readily available for application in several trading consoles as computers have automated the calculation of the Parabolic SAR.
However, to understand how the indicator is developed, here is a brief explanation of its calculation.
Stop, and Reverse (SAR) points are calculated from existing market data. For example, to calculate today’s SAR, yesterday’s SAR is used, and today’s value is used to calculate tomorrow’s SAR value.
In an uptrend, the SAR value is derived from its previous highs. For downtrends, the value comes from the previous lows. The highest and lowest points of the trend direction are referred to as extreme points (EP).
The formula used to calculate SAR value is as follows:
- Uptrend Parabolic SAR = Prior PSAR + Prior AF × (Prior EP – Prior PSAR)
- Downtrend Parabolic SAR = Prior PSAR – Prior AF × (Prior PSAR – Prior EP)
AF is an abbreviation for the acceleration factor. It begins with 0.02 and varies based on new highs and lows set by the market. By default, whenever a new high or low is reached, the AF is increased by 0.02. However, the value caps out at 0.2 until the market reverses direction. Again, EP stands for the extreme point in either an uptrend (highest point) or downtrend (lowest point).
Moreover, traders can vary the capped value of AF to alter the indicator’s sensitivity. If the factor is set higher than 0.2, then the sensitivity increases, presenting more reversal signals. Similarly, an AF set lower than 0.2 will decrease the sensitivity and provide fewer trend reversal signals.
How to Use the Parabolic SAR Indicator
Parabolic SAR is one of the most powerful indicators in the market. But does it mean its implementation is similarly difficult? Absolutely not. PSAR is simple both to apply and to use in predicting the market.
As mentioned earlier, the Parabolic SAR identifies the market’s trend and presents potential entry and exit points for traders to profit. When applied, a sequence of dots runs above and below the price (candlesticks). Generally speaking, a dot below the candle is a signal of an uptrend, while a dot above the candle is a sign that the market could head south.
The PSAR can also be used to set stop-loss orders. It is more like a trailing stop, where traders match the stop-loss price with the SAR dots when the price movement rises or falls. As a result, traders can lock the profits they’ve made before the market reverses its direction.
When to Use Parabolic SAR in Crypto Trading
The Parabolic SAR indicator has great benefits if it is understood and used at the proper moments. And since its features go hand in hand with crypto markets, the PSAR is a crypto analyst’s favorite.
Many traders have the misconception that the PSAR indicator can be applied and interpreted in all markets. But the indicator generally provides efficient results in markets with a dominant trend. Since crypto markets are known for their long-lasting trending phases, this makes the PSAR an ideal choice for technical analysts.
Moving Average and PSAR — The Perfect Combination?
Moving average (MA) is one of the oldest and simplest, yet most powerful indicators. It is used extensively to identify the market’s direction and even reversals to some extent. Therefore, we could say that its functionality is similar to that of the Parabolic SAR.
To understand these indicators’ accuracy, a study performed at the University of Houston-Victoria put each indicator to the test. It found that the Parabolic SAR demonstrated a statistical significance of 95% confidence level, while the simple moving average failed to return results as impressive.
As a result, traders began to blend both indicators as a strategy. Surprisingly, this combination provided better outcomes than using PSAR exclusively.
Markets are unique, but they do follow trends. PSAR is specifically made for the trending market and must be used when the trader is sure that buyers or sellers dominate the market. Additionally, it has been observed when using Parabolic SAR that the accuracy of signals in both consolidating and sideways markets tends to be below average. So to add a layer of certainty to the trend, it is recommended you apply the MA along with the PSAR to filter out false signals.
Applying the moving average to Parabolic SAR is simple. Buy signals obtained with PSAR must be considered when the MA line is below the price action, while sell signals must be considered when the MA line is above the candlesticks. By doing so, traders can gain an edge in predicting market direction.
Strategy 1: EMA with PSAR Crypto Trading Strategy
Incorporating the exponential moving average (EMA) with the PSAR is one of the most reliable strategies. The strategy is based on EMA crossover either above or below the price action. Following is an example of this concept.
Below is a chart of BTC/USDT on the 1H time frame. Analyzing the market from the beginning of the illustration, the MA and the PSAR dots are below the price action. Later, the market dot switches from the bottom of the price action to the top, indicating a reversal in the market. But instead of going short right away, we wait for the EMA crossover. As the price drops below the EMA (as shown in the box), we can trigger a sell signal.
The stop loss can be placed above the EMA crossover or above the highest PSAR dot, to be on the safe side. One can even trail as the market begins to perform in the desired direction.
The trade can be left running as long as the dots are above the price action. Additionally, traders can book some profits along the way at potential support levels.
Strategy 2: Price Action Trading Using PSAR and Trend Lines
The Parabolic SAR is known for identifying trending markets. But it can also be used to identify trend lines for incorporating price action concepts.
In an uptrend, the market progresses, with higher highs and higher lows. As it is challenging for traders to spot the higher lows to draw the trend line, the SAR dots come in handy. Simply joining the progressive dots lying below the price action leads to a perfect trend line, as shown in the below chart (Ether against the US dollar) on the 1H time frame.
Now, if we were to trade using the price action approach, traders could catch hold of a buy position at either the Support & Resistance (S&R) level or at the bottom of the trend line.
A stop loss below the recent SAR dot or S&R is ideal to avoid getting stopped out.
It is ideal for liquidating all positions when the PSAR shows signs of reversal by putting in dots above the candlesticks.
The Parabolic SAR indicator was developed by the same analyst who created the powerful RSI oscillator indicator. Its primary purposes are identifying potential reversals, spotting a new trend or identifying trend continuation, and precision entries. It is an extensively used and trusted indicator to identify an enter and exit signal. Developed for trending markets, when Parabolic SAR is applied with market research and further integrated with other technical indicators and price action concepts to determine the overall trend direction, the results can be very reliable. All in all, the Parabolic SAR does help to prep traders for a contingency plan in case the price falls. However, PSAR shouldn’t be used when the market sideways is approaching as this indicator thrives in a trending environment.
Still, trade signals can be manipulative. To add on, the crypto volatility and the market sentiment add uncertainties to the trade signals. Always do your due diligence to research before trading. Seek professional advice for an investment strategy before trading.