In the last article on indicators, we introduced the Parabolic SAR indicator developed by Wilder. It is a trading system that should show both entries and stops. The Parabolic SAR is therefore referred to as a trend-following indicator.
However, we also had to ascertain that too many false signals are generated within the framework of the general interpretation rules of the indicator. Especially in sideways phases or highly volatile markets, no real edge can be achieved when trading.
So we have to see how the use of the indicator can be optimized. One idea would be to use it only for the identification of entrances or stops. Since some types of trading have a limited term, it makes little sense at first glance to define stops via the Parabolic SAR. However, it is still advisable to consider stop points as possible reversal signals.
Define entrances with the Parabolic SAR
If you look at the silver chart with 4-hour candles, it makes sense to do a simple analysis beforehand after boarding and stops - stops, however, in the sense of potential reversal points, as already indicated. Since we want to concentrate on entry points, the starting point remains a stop point.
This is the case if the Parabolic SAR moves ever closer to the course and touches the course at the end, circled in red on the chart. As the Parabolic SAR is continuously drawn and traders are confronted with too many simple signals due to this, one should only choose those points where the SAR indicator has moved very far from the price. This indicates a very dynamic movement that is weakening again.
However, it should be clear that this analysis method is more suitable for a short-term trading strategy, which can also be described as a kind of counter-trend method. In the case of classic options, which are particularly suitable for trading such strategies due to their short terms, this method is also obvious. To summarize, the important steps are:
- There was a dynamic movement (SAR distance becomes wider towards the course).
- The SAR distance is getting narrower.
- SAR touches the course (possible reversal point or stop point).
In the next step, the entrances should be defined. After we have found a possible turning point, we can either use technical set-ups or other indicators to get started - or even both.
We use two indicators: the short-term moving average of 14 as a set-up replacement and the popular RSI (Relative Strength Indicator). Accordingly, the rules are as follows. To get started...
- a stop point should be identified according to the above three steps;
- the 14 moving average should be under or exceeded.
- Der RSI must indicate a reversal either through divergence or confirmation of the price.
If we go according to the defined entry rules and apply this to the upper silver chart, we receive two trading signals for the entry in the period shown, In the latter case, a stop point was identified, but the MA was not exceeded and the RSI did not show any reversal through divergence or confirmation.
Finally, the question of the correctly selected duration has to be answered. Since we are pursuing a more short-term approach with this strategy - but not so short that we only hold minutes - a runtime between four and eight hours would be an option.
Furthermore, the strategy could be further optimized and For example, stipulate that you only trade put options, since movements downwards are usually more dynamic and you can therefore come faster with the "in the money" option.
Conclusion - Parabolic SAR has the test passed
In summary, the Parabolic SAR can be said that it is less suitable as a trend-following indicator than for the identification of possible short-term turning points. If you apply it to these short-term strategies and optimize it with further entry rules, it can certainly play to its strengths.
However, you should not consider it as a trading system as intended, because the signals come too often in this case. Furthermore, the potential stop points should only be identified as reversal signals in connection with previous dynamic movements.
This ensures that the strong trend cools down and correction is more likely. The more dynamic the previous trend, the stronger the correction could be. Otherwise there is a risk that there will only be a sideways phase in which the Parabolic SAR has its significant weaknesses.