Trading Systems and Technical Analysis: Building an Effective Strategy with the Parabolic SAR

by Andrea Unger

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Many technical analysis indicators are used in systematic trading either as triggers for sending orders or as operational filters.

In this video, we'll show how to create an effective trading strategy based on just one technical analysis indicator, the Parabolic SAR.

The strategy enters at breakouts on levels determined by the Parabolic SAR and always stays at market (SAR stands for "Stop and Reverse").

This is a really simple strategy to program. Since the Parabolic SAR turns out to be already coded in both MultiCharts and TradeStation, it only takes a few simple lines of code.

By watching this video, you'll learn about:

- The Parabolic SAR indicator, how it works and in which markets it can be used

- How to code the Parabolic SAR indicator inside a system (with open source EasyLanguage/PowerLanguage code)

- What results this system would have produced from 2010 to the present

Enjoy! 😎

Transcription

Introduction

Hey everyone and welcome to this brand new video. One of the coaches at Unger Academy here and today we're going to be talking about a very famous indicator known as "Parabolic SAR". Now, this indicator was created in the late 1970s by Wilder Welles and is still used by many investors to make speculative decisions in the financial markets. 

So let's start with the name of this indicator, which is “SAR”, which stands for Stop And Reverse, so it tells us that the indicator will be the operating signal for our trading activities.

The reason the name is preceded by the word "Parabolic" is because of the way this indicator is constructed.

In this slide, I've reproduced the original images from Welles Wilder's book where he showed on graph paper and handwritten spreadsheet, how to construct such points.

Welles Wilder, of course, didn't have a computer at his disposal and so the calculations could seem somewhat cumbersome and complicated. Of course, by now this indicator is already coded in most of the trading platforms out there and so what we'll do now is move to a chart to understand how this indicator is constructed.

How the Parabolic SAR works

So, let's open MultiCharts. Here you can see a chart, it's the Gold future with a daily resolution, and I've plotted the Parabolic SAR on it.

By looking at the chart, we can immediately see that there are some points, which we can call "Mark Points", that are above or below the prices reached by the underlying asset.

Welles Wilder recommends going short when the indicator is above the prices and going long when the indicator is below the prices. The transition between going long and going short is dictated by the performance of the underlying asset.

If the underlying asset, as with this bar, crosses the Parabolic SAR levels, here is where it will start a new bullish trend that will then be closed if it's crossed again, this time on the short side, to reverse the position.

So this will be the stop and reverse level. So that's how the concept of always staying at market is recalled, because we'll always remain at market, but being long or short will depend on the levels calculated.

But let's try to better understand how the Parabolic SAR is calculated. From the first point, so let's assume that we found ourselves in a stop and reverse situation and we're starting a long trade. The first point to locate if the price crosses the Parabolic SAR from when we were short will coincide with the minimum price reached when the position was short.

So, indeed, we were short in this position. The low price reached is this one here, exactly at 1,796.2. The first Parabolic SAR value will be precisely 1,796.2. This is the first point.

The second point, which as you can see is a little bit higher, is calculated based on the difference between the highest high, meaning the highest point that the price has reached since we’ve been long, in this case, the first high of this bar at 1,853.8, minus the previous Parabolic SAR, meaning this level, multiplied by 0.02, which is the first parameter that Welles Wilder considers to be discretionary, namely at the discretion of those who want to use it.

So, the increase will be proportional to the difference between the highest high reached since we've been long and the last Parabolic SAR.

We see here in overlay the formula. So, the difference between this point and this point multiplied by 0.02 gives rise to this new higher point.

In the formula, you’ll see indicated “SIP”, which stands for Significant Point. When we are long, it's the highest high. When we're short, it's be the lowest low. After that, the little number, the multiplier, called “AF” stands precisely for "Acceleration Factor." We'll see in a moment why.

Why is it called “Parabolic”? Because the trend, as you can see here, is quite similar to a parabola. Indeed, this 0.02 multiplier isn't always constant but increases as a new high is formed.

Here, for example, a new highest high of the position is formed, and the increment obtained will always depend on the difference between the highest high and the previous Parabolic SAR, but this time it will be multiplied by 0.04. Indeed, there was an increment of 0.02 because we encountered a new high.

If, as is the case here, a new highest high isn’t reached, then we'll continue with 0.04, which is the last number we found, until we use a new multiplier, 0.006 in this case, when we find a new high.

Here we’ve found a new high. And here you see that the difference between these two points is markedly greater than the difference between these.

I know it might sound a bit complicated in words, even with the formula overlay, however, I guarantee that everything has already been codified in the platforms, so what matters now is just to understand the underlying idea.

And the idea behind it is to have an indicator that follows the price trend. How? By going to check the difference between the highest high reached when we are long and the last plotted Parabolic SAR, multiplied by a certain parameter.

You can then see that there's another parameter, 0.2. This stands for the highest limit beyond which the multiplier can no longer be increased. Indeed, the range of the multiplier goes from 0.02 to 0.2. These are standard parameters that we can, of course, change.

You can see it: we have a step of 0.02 and a limit of 0.2. However, of course, we could also start at 0.02, increase with a larger step and arrive at a higher limit.

Let's give it a try. Here we can put 0.5 and here a 0.08 for example, and we'll see that the indicator changes and it will be much sharper. You see the increment as it follows the price much more and gets much closer and closer.

The Strategy

Well, we just have to go and see how a strategy based on this indicator would behave. For simplicity's sake, I've already coded it and will show it to you, it's super simple.

You can see there are very few lines of code, one of which is to dictate the number of contracts to be used, but we'll see that later. The formula is indicated in this line.

Indeed, all we have to do in EasyLanguage or PowerLanguage is to write “Parabolic SAR”, put in the inputs that we've talked about now, namely our step and limit, and then we'll get Var1, which is an output that gives us the value to be used for setting the stop orders. Indeed, they'll all be breakout stop orders.

And now let's activate this strategy on the chart. We'll go back to the default parameters. Let’s enter our study and use the same parameters.

And here's our strategy, which goes short when the price crosses the Parabolic SAR, goes long when it crosses it again but from the bottom up, and so on. Welles Wilder recommends using this indicator on instruments which respond well to breakout logic such as commodities.

So, what could we do? We could test this strategy on a portfolio of instruments. Here, for example, I've prepared one that contains several commodities. Here we don't have stock and bond indexes or whatever. We only have commodities that respond well to breakout logics.

We can apply our signal with the standard parameters. The charts will all be daily, with a timeframe of 1440 minutes. Let’s do a backtest starting from 2010 and we’ll see that it seems to work.

I see very positive results. Remember that there's a logic of position sizing based on volatility, but this is simply to make all the instruments comparable.

So let's go and take a look at the equity line. As you can see it's an increasing equity line. It isn't very efficient because the average trade now is at $1,500, but if we were to take a single contract... And we can do that right away... we’ll see that it wouldn't be capacious enough to cover all the slippage and commission costs. In any case, it’s a very good average trade to start with, since it's about $92.

The number of trades is 4,500. Let's go and look at the equity curve with one contract. It's a little bit distorted because the larger instruments predominate, but still, you can see that the strategy is pretty good.

And this strategy is based only on the Parabolic SAR. So it's up to you now to move forward from this point, and go and add a stop loss, a take profit and maybe some operational filters to go and see whether or not the Parabolic SAR could become an effective instrument for creating your own trading systems.

Welles Wilder used to do it manually. We have got MultiCharts or TradeStation and can backtest in a few very simple lines.

So if you want to learn more about this world of systematic trading and about testing ideas or strategies even from a long time ago, we follow one method, which is that of 4-time world trading champion Andrea Unger. And at the link you can find in the description of this video you can find a lot of useful information, including a free presentation by Andrea Unger, getting our best-selling book "The Unger Method," by just covering the shipping costs or you can also book a call with a member of our team to get a free strategy consultation.

Finally, I'd like to remind you, if you haven't already done so, to subscribe to our channel so that you'll stay promptly updated as new videos are released. And if this video was helpful to you, also please, leave us a Like.

We'll see you soon with more videos and trading tips and insights. Bye-bye!!

Need More Help? Book Your FREE Strategy Session With Our Team Today!

We’ll help you map out a plan to fix the problems in your trading and get you to the next level. Answer a few questions on our application and then choose a time that works for you.

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Andrea Unger

Andrea Unger here and I help retail traders to improve their trading, scientifically. I went from being a cog in the machine in a multinational company to the only 4-Time World Trading Champion in a little more than 10 years.

I've been a professional trader since 2001 and in 2008 I became World Champion using just 4 automated trading systems. 

In 2015 I founded Unger Academy, where I teach my method of developing effecting trading strategies: a scientific, replicable and universal method, based on numbers and statistics, not hunches, which led me and my students to become Champions again and again.

Now I'm here to help you learn how to develop your own strategies, autonomously. This channel will help you improve your trading, know the markets better, and apply the scientific method to financial markets.

Becoming a trader is harder than you think, but if you have passion, will, and sufficient capital, you'll learn how to code and develop effective strategies, manage risk, and diversify a portfolio of trading systems to greatly improve your chances of becoming successful.