The Parabolic SAR, also known as Parabolic Stop and Reverse, is a trend indicator primarily used in Forex trading to discern the future short-term momentum of a particular asset.
The famous technician J. Welles Wilder Jr. first introduced the indicator in his book, New Concepts in Technical Trading System.
Forex traders can apply this indicator alongside a trading strategy to determine where to place stop orders. It’s also great for finding entry and exit points.
How to Calculate the Parabolic SAR in Forex Trading
Using the Parabolic SAR can be rather complicated, and it goes beyond the scope of how most traders use it in Forex. Nevertheless, when a trader understands how to calculate the Parabolic SAR, using the indicator for trading will become easy.
The indicator uses the most recent highest and lowest prices at the extremes, combined with an acceleration factor (AF) to determine where the indicator dots will appear on the price chart.
For every step in a trend, the PSAR value gets calculated from the previous period. In other words, yesterday’s data drives today’s value.
The formula of the PSAR consists of the following:
- For an uptrend: PSAR = Previous PSAR + Previous AF (Previous EP – Previous PSAR)
- For a downtrend: PSAR = Previous PSAR – Previous AF (Previous PSAR – Previous EP)
- EP represents Extreme Point, which equals the highest high in an uptrend and the lowest low in a downtrend. Any time price reaches an extreme point, the PSAR gets updated.
- AF represents Acceleration Factor; the default value is 0.02. The AF increases by 0.02 every time price reaches a new EP, and it has a maximum value of 0.20.
The calculation produces dots above a falling price movement or below a rising price movement.
The PSAR dots above or below price help to show the present price direction. The dots flip above the price bars when the price falls below the rising dots; when the dots flip below the below price, price rallies through the falling dots.
Fortunately, chart trading software does all the calculation in the background.
Here’s an image showing how the PSAR looks on a trading chart (MT4 or MT5).
The image above shows how the Parabolic SAR looks in a Forex Trading chart for USD/JPY.
As seen in the image, the dots form above the price candles in a downtrend; it forms below them in an uptrend. As for the range market, the dots look choppy, forming both above and below the price bars.
How to use the Parabolic SAR to trade in Forex
The primary use of the Parabolic SAR indicator is to sell when the dots form above the price bars, indicating a downtrend, and to buy when the dots form below the price bars, indicating an uptrend.
The PSAR produces constant trade signals and puts a trader in a good position. The signal is even stronger when price makes big swings forth and back.
Consequently, a trader makes large profits on each trade. However, a trader can only make small profits when price makes small moves and has many losing trades in a row.
For that reason, it’s advisable to analyse the price action of the day by using other chart tools to determine if there’s an uptrend or downtrend. In other words, the PSAR shouldn’t function on its own.
A trader can combine momentum and moving averages indicators with Parabolic SAR to confirm an overall trend direction. Trade signals should only be taken in the direction of the overall trend.
This image shows how Moving Averages and Momentum indicators merge with the PARS to generate a robust trade.
It is advisable to take short trades when there’s an overall downtrend based on chart analysis. Moreover, the PSAR dots must appear on top of the price bars to confirm the trend. When the dots flip below the price bars, it’s time to exit the market.
A trader can use the PSAR to monitor the strength of a trend while catching trend moves.
What are the advantages of the Parabolic SAR?
The primary benefit of the PSAR indicator is its ability to indicate a strong trend when one exists. As a result, it allows a trader to stay in the trend direction of price.
Also, the Parabolic SAR helps a trader know the best time to exit the market—when the price is going against the trend, signalling a reversal. It could end up being a good exit point when the trend reverses.
The image above is showing how a trader can make good profits with Parabolic SARS in a stable Uptrend or Downtrend.
The disadvantages of the Parabolic SAR
The main drawback of this indicator is that it doesn’t provide as much trading insight during a sideways or range market. The PSAR dots constantly form below and above price bars when the price is moving sideways.
Therefore, traders may experience a significant loss if they only depend on Parabolic SAR for trade confirmations, especially during a sideways market.
The image above shows how the indicator reacts in a range market. A trader should avoid the market at such time.
The bottom line
The Parabolic SAR is a powerful indicator that is great for getting into trades (buy or sell), determining price direction, and setting stop losses in Forex trading.
Nevertheless, it’s risky to trade based on this indicator alone. To get the best results, a trader should combine it with other indicators, such as the momentum and moving average indicators, to make good profits in Forex.
The Chaikin Money Flow (CMF) indicator and the Money Flow Index (MFI) both measure the flow of money into and out of an asset, but they are polar opposites when it comes to how they are calculated and used by traders.
One of the best ways to compare the two indicators is to think of the Chaikin Money Flow as being very similar to the MACD indicator in the sense that it is calculated using the exponential moving averages (EMAs) of the accumulation/distribution lines.
The Chaikin Money Flow is an indicator whose values range between a high of 1 and a low of -1, which represent the extremes, or the tops and bottoms, of a bullish or bearish trend.
On the other hand, the Money Flow Index is calculated using a volume-weighted measure, such as the relative strength index (RSI), instead of using an exponentially weighted moving average like the Chaikin Money Flow (CMF) indicator does.
Figure 1: The Chaikin Money Flow indicator
How to calculate the Chaikin Money Flow (CMF) indicator
The Chaikin Money Flow is calculated in four steps, starting with the calculation of the money flow multiplier for each period. The second step is to multiply the volume for each period and the period’s money flow multiplier to determine the Money Flow Volume. Third, add up the money flow volume for each period (20 periods) and divide the total with the sum of the volume for the 20 periods to find the Chaikin Money Flow.
- Money Flow Multiplier = [(Close – Low) – (High – Close)] / (High – Low)
- Money Flow Volume = Money Flow Multiplier x Volume for the Period
- 20-period CMF = 20-period Sum of Money Flow Volume / 20-period Sum of Volume
The money flow multiplier
This is the foundation of the Chaikin Money Flow and is calculated using an asset’s closing price at the end of a chosen period, such as five minutes, 30 minutes, an hour, four hours, or a day. The money flow multiplier has a negative value when the close is in the bottom half of the high-low range for a particular period; it is a positive value if the close is in the top half of the range.
However, we use the absolute value of the money flow multiplier when calculating the Chaikin Money Flow, which has a major impact on the values seen in the money flow volume.
The Money Flow Index
The biggest difference between the Money Flow Index and the Chaikin Money Flow is that the MFI is an oscillator whose values range between 0 and 100, while the Chaikin Money Flow is basically an average of different exponential moving averages.
The MFI is unique in the sense that it incorporates both volume and price data; other oscillators only display price data, which is why some chart technicians refer to it as a volume-weighted relative strength indicator.
Figure 2: the money flow index
How to use the Money Flow Index
The MFI is calculated using a default value of 14 periods, where a reading below 20 is considered as oversold and a reading above 80 is regarded as being overbought. However, it is important to note that an oversold or overbought reading does not mean that the trend is about to change.
Trading the markets is not easy, and in many cases, overbought conditions may get extremely overbought before the trend reverses. The same is true for oversold conditions, which may get extremely oversold before a sudden reversal.
The creators of the MFI, Avrum Soudack and Gene Quong, propose that traders use 90 as an indicator of overbought conditions and 10 as an indicator of oversold conditions that are about to reverse when using the MFI to time their trade entries and exits.
The main drawback of using 90 and 10 as trade entry and exit points is that these are extreme levels that are rarely reached and are therefore likely to generate very few trade signals. Nevertheless, they provide some of the best trade setups if activated.
The bottom line
The Chaikin Money Flow and the Money Flow Index both track the flow of money into and out of an asset as well as the momentum of price movements. However, they are calculated and work quite differently. The Chaikin Money Flow (CMF) generates more trade signals than the Money Flow Index (MFI).