The parabolic stop and reverse indicator (a.k.a PSaR) is a trend following indicator designed to allow traders to adequately follow trends while maintaining a clear stop level to allow for adequate exits if price reverses. This indicator has been widely used in technical analysis for both discretionary and algorithmic trading with its use being the center of several different strategies – most centered around the capturing of long term trends. Within this post on the indicator series I will talk to you about the calculation of the PSaR, what this indicator allows us to know about price action and how it might be used for the creation of successful algorithmic trading strategies (both trend and counter trending). After reading this article you will have a basic idea about what the Parabolic Stop and Reverse does and how you can use it for your own trading.
The PSaR indicator is built on the principle that – within a trending period – higher highs or lower lows will be made without retracements exceeding a certain magnitude. Whenever the magnitude of the expected retracement is exceeded the indicator will “reverse”, signaling the start of a trend in the other direction. This is why the PSaR is called “Stop and Reverse” because the touching of the indicated expected retracement level is the signal to stop a position and start one in the opposite direction. In order to better understand how this works we first need to understand how the PSaR is calculated (definition taken from here):
- EP = Highest high for a long trend, and lowest low for a short trend, updated each time a new EP is reached
- AF = Default of 0.02 (2%), increasing by 0.02 (2%) each time a new EP is reached, with a maximum of 0.20 (20%)
- PSaR = PSaRn + (AF * (EP – PSaRn))
In general the PSaR of the first bar is defined at either the high or low of the bar from which the following PSaR values are defined. Whenever a bar closes below/above (depending on current direction) the PSaR of the last bar the PSaR of the current bar is reset to either the high or low value over the whole previous movement (going into the opposite direction, meaning the EP is updated).The AF (Acceleration factor) is used to make sure that you start to trail “closer” to price as the market moves further into a trend. The reasoning behind this is that a trend which has lasted for a longer period of time has a higher possibility to reverse.
In general the PSaR is used as a tool to follow trends, using the value of the PSaR as a trailing stop to know when you should exit the market. However the PSaR is seldom used as a unique entry criteria since it will not work correctly unless the trend has been established with a certain degree of success. This is why the PSaR is often used mainly as an exit management criteria or as a way to confirm entries in a certain direction. The PSaR is also used as a way to profit on currencies which show a lot of mean reversion since the PSaR can – under these circumstances – serve as a TP for range trading instead of a simple SL.
In general you will see that the PSaR is very good at capturing slow developing medium term trends which have limited retracements but will fail on either choppy trends or markets which have explosive moves followed by sharp reversals. The indicator is particularly good at capturing trends that have increases in momentum within the middle and then fall passively near the end since the PSaR is able to adjust to the last support/resistance level of the trend, allowing you to capture a substantial amounts of the profits being produced.
The acceleration factor also plays an important role in the effectiveness of the PSaR. If the expected trends will develop very fast then high acceleration factors are vital while trends that tend to develop slowly in which more tolerance for retracements needs to be had will usually do a lot better with a lower multiplier. A higher AF simply implies that you will trail the developing trend closed while a lower AF means you will leave more space for moves against you before exiting positions.
The PSaR tends to work better under higher time frames, especially when the general trend direction is known. In this case a big PSaR move is interpreted as the dominating trend and a trade is entered whenever a retracement against this direction ends. This ensure you avoid losing trades due to entries in the direction of retracements and ensures a well trailed profit from the following of developing trends in the most favorable direction.
In my experience the PSaR is rarely efficient with the same settings on all pairs since the AF will be vital in allowing you to effectively exploit trending or ranging inefficiencies on different pairs. The PSaR will work most effectively on the daily time frame but it also might be used with success on lower time frames, although probably only as either a money management or entry confirmation tool. The most successful entries – as I have experienced – arise from previous determination of trend direction, entering on the reversal point of a retracement (all of this within daily charts).
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