The next technical analysis indicator which should be paid attention to in the process of Forex education is the Parabolic Stop and Reversal System (PSAR). This indicator was developed by the famous trader Welles Wilder, who contributed much to the research and development of financial markets technical analysis. Using this indicator in a propper way, one can significantly reduce the number of trading mistakes and thus, increase the profit.
The name of the system is derived from its parabolic shape which follows the price movements in the form of a dotted line. The indicator’s parabolic form is explained by the mathematical formula. The important condition of this indicator use is the existence of a well-defined trend on the market – in such case the indicator can give a good signal that the trend is weakening or reversing, i.e. the good signal for position closing in one side and its possible opening to another one. If price fluctuation emerges in the horizontal range, then this indicator may give many false signals. Therefore, before using the indicator you should research the market for the presence of the existing trend on the analyzed currency pair. For that, you may need such technical analysis instruments as support and resistance levels, trend reversal patterns, trend continuations patterns, moving averages, Bollinger bands, moving average convergence/divergence (MACD) and others.
The indicator is a dotted curve. Each dot corresponds to its own trading period depending on predetermined scale of the price chart, but, usually, daily charts are used. If the indicator's curve is placed below the price line, then it signals about an upward trend. If the curve is above the price indicator, it signals about a downward trend. At that moment, when the curve of the indicator crosses the price line, the trend is weakening and there is a good chance of the trend reversal. The approach of the PSAR system curve to the price line witnesses about the trend weakening. The distance between dots shows the trend intensity – the longer distance is, the stronger trend becomes. But remember that the trend can reverse at great speed!
It can be noticed that the indicator's curve is dashed. When the curve crosses the price line, next point of the indicator jumps over to opposite side of the price line. Such behavior is determined by a well-defined algorithm. This algorithm is based on two concepts: an extreme point and an acceleration factor. During the upward trend, the extreme point is the trend’s highest price. During the downward trend, the lowest price is the extreme point. As soon as PSAR signals about the trend reversal, the algorithm varies to the opposite. When such signal appears, the acceleration factor is reset to its initial value. Usually, it is set to a value of 0.02 (2%) initially. This factor is increased by 0.02 each time a new extreme point is recorded and the extreme point is updated with that value. The same factor increase and extreme renewing appears if the closing price of the current trading period is less than the extreme point of the downward trend. The indicator is calculated with time advance, that is today’s data is used for the calculation of the indicator value for tomorrow. The mathematics formula for estimation of the parabolic SAR indicator is recursion and has following form:
SAR(n+1) = SAR(n) + AF * (EP – SAR(n)),
where SAR(n+1) is the indicator value for tomorrow,
SAR(n) is the indicator value for today,
AF is an acceleration factor and EP is the last extreme point.'
Apart from this, for estimation of the indicator, several additional conditions are used:
if tomorrow's SAR(n+1) value is within or beyond the today's (n) or the yesterday's (n-1) trading day price range, then its value is set below the low border of this range. For example, if during the upward trend the indicator value is higher than the lowest price, recorded during the last two days, including today, then the indicator takes on a value of the lowest price; for the downward movement the converse proposition is correct;
if tomorrow's SAR (n+1) value is within or beyond the tomorrow’s price range, then the trend reversal signal appears, and the indicator computation algorithm have to switch over “the phases”.
As soon as the trend reversal takes place, i.e. the algorithm phase switches over, the PSAR indicator value for a new trend is set at the last recorded EP of the previous trend. The EP is set at the highest point, if the new trend is an upward and at the lowest point, if the new trend is downward. The AF is reset to the initial value of 2%.
The PSAR indicator can be used as stop loss during Forex trading. The technical indicator value always lags the price that is why when you enter the market, it is possible to set a stop loss at the current value of the indicator. But before, make sure that such approach does not breach your capital management strategy when Forex operations are carried out. In addition, the PSAR indicator can be used as take profit, when the indicator's curve comes closely to the price line or crosses it.
The important notice is that this indicator can give many false signals if the deals on the currency pair are in horizontal diapason. You should use this indicator only if the trend may be confirmed by other technical analysis instruments. In general, the internet trading should never be attended by making decision using just one technical analysis instrument – always use several instruments. Make trading decisions on opening and closing of positions only if most of the used instruments give the same trading signal.
After the PSAR indicator's curve has crossed the price line, wait until a number of following dots of the indicator confirm a new trend appearance and only then open positions. Close your positions, when the curve approaches to the price chart closely and crosses it. The indicator signal appears with a delay; therefore, if you close the positions too late, you will lose a part of the profit. Remember, that after the new trend formation, its strength is confirmed by the distance between the indicator curve dots – the longer the distance is, the stronger the trend is. As a rule, the trend acceleration takes place after the 4-5th dot, that is why such acceleration can be a good confirmation of the correct trading decision. Entering the market, when the trend has strengthened enough, can be dangerous, because there is a great probability of the correctional movement or reversal. Therefore, it is risky to open positions at the moment when the distance between the PSAR indicator curve dots is long.
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