Parabolic SAR Forex Breakout Strategy

Introduction

This strategy is a breakout strategy which will involve the use of several indicators as an alternative method of finding breakout situations. The four hour chart is the chart used in the analysis of this strategy. We will use trend indicators to identify the new trend, and a momentum indicator to detect the strength of the breakout move.

Indicators

The indicators used for this trade setup are as follows:

  1. a) 200SMA: This will be used as a trend indicator. Due to the relatively large period that this indicator works with (200 days), it will be used as a way of assessing market bias for the trade. We will therefore work with the assumption that if the price action is above the 200SMA, the market bias is bullish. A bearish bias is held if the price action is below the 200SMA. For our trade example, this indicator will be coloured gold.
  2. b) The 13-day simple moving average (13SMA) uses a short time period. It will thus be used as short term support for long trades and as a short term resistance for short trades.
  3. c) Parabolic SAR indicator. The Parabolic SAR rounds off the trend indicators. When the dots of the indicator are above the price action, this is a bearish signal. A bullish signal is seen when the indicator dots are located below the candlesticks.
  4. d) Colored MACD indicator: A red colour is bearish; a blue colour is seen to be bullish.

The Strategy

This strategy requires all indicators to speak with one voice. We will be looking for a situation where the three trend indicators are imparting a bullish bias for the trade at a time that the MACD histogram is showing a blue colour. This is the long trade signal.

1) Long Trade
The long trade setup is as follows:

  1. a) Price action is above the 200 SMA (market bias is bullish)
  2. b) Price action is seen to be taking off from the short term support line, the 13SMA indicator.
  3. c) At the same time, the Parabolic SAR indicator dots are found below the candlesticks.
  4. d) MACD histogram has a blue colour.

The snapshot below shows the trade setup which should be used for the long trade. Due to the fact that the 4hour chart is the time frame of choice, a trader may discover that there will be several opportunities to initiate this trade within a one week period.

parabrklong

Long Trade Setup

This chart shows the price action over several days, which presented three possible trade opportunities. Usually, the trade is opened as the candlesticks bounce off the 13SMA.

Short Trade
The short trade setup is as follows:

  1. a) Price action is below the 200 SMA (market bias is bearish)
  2. b) Price action is seen resisted at the short term support line, the 13SMA indicator.
  3. c) The Parabolic SAR indicator dots are located above the candlesticks.
  4. d) The MACD histogram has a red colour.

When all these signals appear, the trader can initiate the short trade at the exact point where the price action is resisted at the 13SMA line.  An example of the short entry setup is seen below.

parabrkshort

Short Trade Setup

In this example, there are two possible entry points. Entry point 2 is valid because the Parabolic SAR and MACD indicators are still showing bearish bias. The stop loss for the trade is set above the 13SMA indicator, and the Take Profit is left with dynamic levels, in which case a reversal of the Parabolic SAR and MACD signals should alert the trader to exit the short trade.

Stop Loss

The stop loss for each trade must be set not just on the other side of the 13SMA line opposite to the direction of the trade, the stop loss must also be set either below the Parabolic SAR dots for a long trade, or below the Parabolic SAR dots for the short trade.

Take Profit

The Take Profit area is usually defined by the trader in a discretionary manner. In the midst of this discretion however, the trader should be able to use technically sound parameters to decide on where the profit targets should be fixed.

Conclusion

The strategy performs best when the market is trending. However, there are times when the market will remain range-bound. A range-bound market does not mean that no money can be made from this strategy. It only means that the amount of pips that can be made will reduce. The essence of using the 4 hour chart is to ensure that profits of an average of 30 pips can still be made from each trade in the presence of flat markets. This requires a lot of vigilance from the trader.

Trending markets give much better performances of an average of 150 pips. The 200SMA can be used to detect the trend of the market. Usually the 200SMA will point in the direction of the trend. It is almost horizontal when the market is flat. So this strategy has profits to give away for the discerning trader.

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