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Parabolic SAR Indicator
Parabolic SAR (Stop and Reverse) is an indicator developed by J. Willes Wilder to discover and exploit profitable trends in all kinds of markets. It is a popular tool among technical traders, and a straightforward and as a simple mechanism for analyzing the markets, it offers some unique advantages over other tools.
Below we have a chart of the EURUSD pair depicting the Parabolic SAR in action. We observe that the indicator was able to capture many small reversals with remarkable accuracy. And in those cases where it failed, we see that the thrust of the market action was strong enough to place it into a correct configuration, thereby minimizing the potential losses of a faulty trade.
Calculation of the Parabolic SAR
Parabolic SAR is calculated by a recursive formula which ties the prices of one period to another through simple arithmetics.
SAR of Today = SAR of Yesterday + a (EP- SAR of Yesterday)
Or
SAR of Tomorrow = SAR of Today + a(EP-SAR of Today)
EP is the maximum recorded during the time period in consideration. If during each period of analysis a new record is broken, the EP will be updated accordingly, and the SAR value will change.
"a" represents the acceleration factor. It is set at 0.02 in the beginning, and reset each time a new EP is achieved. This is to ensure that the indicator's value will come closer to the EP value every time a new record is broken, but the maximum value for the EP is usually set at 0.2 in order to prevent it from becoming too large and distorting the analytical picture. Due to the higher volatility of the forex market, traders prefer to give an initial value of 0.01 to the acceleration factor on the basis that frequent fluctuations, leaps and bounces in the price action do not justify attaching a lot of significance to arbitrary price highs.
Once the SAR value is calculated one of two courses will be taken in order to derive the signal from the indicator. If tomorrow's SAR remains within today's or yesterday's price range, the indicator is set at the lowest price during that time period. For example, if the SAR is slightly above yesterday's opening lowest price, or close to, but below, yesterday's high, the indicator will be set at today's lowest price.
If on the other hand, tomorrow's SAR value is within tomorrow's price range, the indicator will switch sides. If it is below the price action, it will move to the upside, and if it was on the upside it will come below, signifying a trend switch.
Trading with Parabolic SAR
Parabolic SAR is generally regarded as a trend indicator, since other types of markets tend to generate false signals leading to whipsaws and fake breakouts. The best way of trading the Parabolic SAR is to first gauge the direction of the market by using simple tools like trend lines, moving averages, or tools like the average true range, before using Parabolic SAR to trade the shorter-term fluctuations that can be exploited within a longer term framework.
When it is drawn on a chart, the Parabolic SAR will indicate a bullish market if it remains below the price, or supports it, and when it is above the same it is regarded to be suppressing the prices, indicating bearish conditions. Not only is it possible to regard this phenomenon as a signal for the opening of a position, but it also makes sense to use the Parabolic SAR as a stop or take profit level in each trade. For instance, when the price action is bearish, and we have a sell order, one can choose to exit the position when the price action approaches the SAR level by a predetermined number of pips. When the market action is bullish on the other hand, we can use the Parabolic SAR as a support level, and when the price gets too close to it, we can liquidate the trade. It is also possible to use a time-stop while trading with this indicator. In this case, there is no necessity of a market reversal. Instead we determine a timeframe during which the trade will be kept active, but when that period is out, we'll liquidate it even if the Parabolic SAR indicator is indicating positive conditions. This course of action is justified on the basis that in a strongly trending market where this indicator is most useful, lack of progress can be a sign of approaching reversal.
Conclusion
This indicator is most useful in a trending market. It is best to use it in combination with other indicators that establish the general direction of the trend at a higher level, while trading short-term volatility with the SAR. The advantages of this technical tool are its simplicity, clarity of signals, ease of interpretation, and tendency to generate concrete points of action during a trending market. These same strengths are also the weaknesses of the indicator. It is sometimes the case that the solid signals of the SAR indicator lack any practical basis. To avoid such conditions, we suggest that you use the SAR indicator with oscillators that signal emerging divergence/convergence scenarios, so that the common problem of whipsaws are reduced in frequency. Ultimately, of course, our best guide should always be money management and prudence in trading, beyond any single technical indicator
Elliott Wave Theory
Elliott Wave Theory is a popular method of analysis that applies a technical approach with a fundamental analysis interpretation. Elliott Wave Theorists also concentrate on the price action strictly, and agree to the notion that the price is the beginning and end of all analysis, but they recognize that there exists an important relationship between liquidity, credit, and economic robustness which underlies the existing price patterns in the market.
The Wave Theory was first proposed by Ralph Nelson Elliott, an accountant, in the 1930s. Elliott's approach was condensed into its definitive form in his 1938 book "Nature's Laws - The Secret of the Universe" in 1946. Since then, the theory has been regarded both as pseudo-science, and as an effective method for dealing with the uncertainties of the market. Academics tend to disregard it in general, while some famous trading personalities, such as Robert Prechter, and Paul Tudor Jones claim to have attained success by using it.
Calculation
The Elliott Wave Theory is based on the cyclical nature of market events. Most traders are familiar with the fact that market events, and economical conditions tend to recur in time with a varying frequency. A growth phase may be exceptionally long, or a recession (and a bear market may surprised to be exceptionally harsh and deep, but the nature of trading and economic activity ensures that sooner or later the existing conditions will revert to the opposite, and the market
Trading with the Elliott Wave
A wave theorist will divide the price pattern into several sub-patterns and consider trade opportunities on the basis of trends that exist at lower levels. Although Elliott Wave Theory is often discussed in the context of decades or years, the fractal nature of the price action enables the application of the theory at any timeframe.
Wave theory divides price action into five main phases. At the first phase, the trend is barely obvious as only a small number of traders are aware of its emerging potential. At phase two, there is a small correction, but it never brings prices below the inception point of the trend. Phase three is the strongest and most powerful, and also drives a large number of bystanders into the price action. Phase four is the ensuing corrective phase, and phase five is the final, bubbling phase of the trend where everyone is bullish and massive amounts of capital enter the market. Phase five is followed by a collapse which ends the trend.
Deciding where each of these phases begins or ends is mostly a matter of intuition. As such, there are no generally accepted methods, and each trader will sooner or later improvise his own techniques for determining the time frame of a trend. This is not necessarily a problem, since the best way of coping with the resultant failures and losses is choosing a strategy that will accommodate your risk tolerance and mental resilience in trading. Since each person is different, interpretation of Wave Theory also varies from person to person.
Conclusion
Advantages
The main advantage of the Elliott Wave Theory lies in the organization and compactness that it grants to the chaotic and price action. By reorganizing the market patterns into an easily understood hierarchy, the Wave Theory allows greater precision in trade decisions, increasing the trader's confidence, and widens his horizon by stretching the field beyond the randomness of short-term market events. All these make it possible to formulate more sophisticated and advanced strategies in trading while still keeping the necessities and implications of the immediate market action in mind.
Disadvantages
The weakness of the Elliott Wave Theory is its arbitrariness. It is rare to have two analysts examine the same chart part pattern and reach the same conclusions or draw the same wave patterns as a result. Indeed, it is almost possible to imagine a complex price pattern on which a large number of analysts will reach consensus.
The main reason of this problem is the intuitive, fluid formulation of the theory itself. By attempting to place market dynamics into the strict formalism of a deterministic theory, the analyst deprives himself of the benefit of the insight that prices will and often do move for reasons which do not in any way accept explanation by referencing the past. In other words, it is possible that the market will create recurring patterns that appear to be cyclical without any simplistic underlying causality based on patterns and visual analysis. And when the wave theorists try to disregard this fact and confine the price into an arbitrary structure devised on very strict rules, the outcome is a rainbow pattern of scenarios that have little relationship to actual market dynamics, or the realized future market trends.
In summary, we can say that the Wave Theory is useful as a tool for organizing one's opinion about the markets, but it has very little predictive power in the storm of real market action. One could certainly use the theory to generate entry/exit points for trades, but success is only possible if the notion of precision is discarded, and the data is evaluated with strategies suitable to a chance game.
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