Last Updated on August 13, 2021 by Mark Ursell
This article is a comprehensive guide about how to trade with the PSAR indicator.
You will will read about:
- What the PSAR does
- How to calculate the PSAR
- PSAR buy and sell signals
- What type of markets to trade
- How to choose the best PSAR settings
- Case study examples
Whether you are just getting started with the PSAR or you have been trading it for years and want to learn more, this is the article for you.
You might find the best PSAR settings a surprise – I certainly did!
Watch the Video
Check out my video explaining the PSAR. You can see me showing how to use the PSAR and demonstrating the best settings in my analysis.
What is the PSAR?
The Parabolic Stop and Reverse system (PSAR) was introduced by J. Welles Wilder Jr in his classic book: New Concepts in Technical Trading Systems
The PSAR is a trend following indicator that changes direction when it is touched by price. During downtrends, the PSAR is above the price. During uptrends, the PSAR is below the price.
The More Powerful the Trend, the Faster the PSAR
The PSAR has a built-in acceleration factor.
When a trend begins, there is only a small gap between the dots. But as the trend speeds up, the PSAR begins to accelerate. This is what gives the PSAR the classic ‘parabolic’ shape.
New Concepts in Technical Trading Systems
If you want to get a deeper understanding of where a lot of our modern technical trading indicators came from then you really should check out Welles Wilder’s book. It is accessible, easy to read and encouragingly scientific approach to trading.
“Letting your emotions override your plan or system is the biggest cause of failure.”J. Welles Wilder, Jr
How Does the Parabolic SAR Indicator Work?
The PSAR has three inputs.
- Initial Acceleration
- Acceleration Step
- Maximum Acceleration
Sometimes there are only two inputs which means that initial acceleration and acceleration step are combined.
Initial Acceleration and Acceleration Step
This sets how fast the PSAR dots move.
In an uptrend, when the price makes a new high, the acceleration factor increases.
In a downtrend, when the price makes a new low, the acceleration factor increases.
This is the speed limit for the indicator. The acceleration factor can increase up to this value but no further.
How is PSAR calculated?
First PSAR Value
In an uptrend, the first PSAR value is the low of the previous downtrend.
In a downtrend, the first PSAR value is the high of the previous uptrend.
Subsequent PSAR Values
The Extreme Point
In an uptrend, the Extreme Point is the highest high since the uptrend began.
In a downtrend, the Extreme Point is the lowest low since the downtrend began.
The Basic Calculation
The basic calculation for the PSAR is surprisingly simple:
Uptrend: Previous PSAR + ((Extreme Point – PSAR) * Acceleration Factor)
Downtrend: Previous PSAR – ((Extreme Point – PSAR) * Acceleration Factor)
One More Rule…
The PSAR calculation has one other rule.
In an uptrend, the PSAR should be no higher than the low of the previous two bars.
In a downtrend, the PSAR should be no lower than the high of the previous two bars.
Calculate the PSAR in Excel
If you want all the formula and a step-by-step guide, check out my article here about: How to Calculate the PSAR in Excel
“[The PSAR] should be used primarily in a directional market.”J. Welles Wilder, Jr
How to Trade With the PSAR
The PSAR is a complete system, trade long when the price is above the PSAR and trade short when the price is below the PSAR.
You can combine this with other approaches. For example:
- Stock traders might only use it trade long
- Many traders use the PSAR as an exit only
- You can combine it with other indicators such as the EMA (check out my example below)
- Combine a slower and a faster PSAR
But Here’s the Catch…
Whichever method you use, the key to trading success with the PSAR is:
- Trading the right markets
- Using the best settings for that market
Trading the Right Markets
As Wilder said in the quote above. The PSAR should be used in directional markets. This means markets that are trending strongly or likely to trend strongly.
Wilder recommended combining the PSAR with an indicator that identifies the trend. His suggestion was the ADX and you can see in the chart below the PSAR combined with the ADX on Apple Inc.
There are many other ways to identify the trend. Scanning with RSI indicator can tell you which markets are trending and which are flat.
You can use market relative strength to identify the best stock sectors. RRG Graphs are a nice way of viewing the strengthening and weakening sectors.
“Some traders are born with an innate discipline. Most have to learn it the hard way.”J. Welles Wilder, Jr
How to Find the Best PSAR Settings
The second key part of success with the PSAR is choosing the best settings. But how do you find the best settings?
You Have to Look at What Has Happened in the Past
By checking the historical patterns – there is no other way!
This is difficult and time-consuming to do manually, which is why most advice suggests sticking to the traditional settings. Or gives suggestions based on the author’s experience.
Now You Can Test in Excel
Excel is by far the world’s most popular analytical software. It is familiar to most people who use a computer and I have created a backtesting tool that you can use directly in Excel.
The latest Tradinformed Backtest Model includes an optimization tab that you can use to find out the best settings for any market or timeframe.
When I use the optimizer I am looking for patterns. I am not looking for a specific combination of settings that will predict the future.
I want to know what has worked in the past as a guide to what is most likely to work in the future.
When I tested the EUR/USD with the PSAR I found a massive difference between the traditional settings (which were not profitable) and the best settings (you can watch the video above to see me demonstrate the model and review the best settings).
I tested on the daily timeframe on the EUR/USD between 2010 and September 2020. My key finding was that:
Faster PSAR settings were consistently more profitable than slower PSAR settings.
|PSAR Value||Optimal Range|
|Initial Acceleration & Step||0.1 – 0.2|
|Maximum Acceleration||0.4 – 0.6|
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