Technical analysis of Forex by Parabolic SAR

Indicator

SEYED HADI MIR YAZDI ZIBA HABIBI LASHKARI

Faculty of Business and Accountancy (FBA), International Business School (IBS),
University of Malaya (UM) University Technology Malaysia (UTM)
Kuala Lumpur, Malaysia Kuala Lumpur, Malaysia
[email protected] [email protected]

Abstract: In these days, trading automation is one of the 1.1. Fundamental Analysis in Forex Trading
major topics in the field of financial research. Buy and sell are Fundamental analysis (FA) is a method of determining asset
the key rule to an automated trading system which is possible valuation based on key underlying factors. For Forex
to generate by various technical indicators in Forex (Foreign transactions, significant factors are economic indicators of a
Exchange) market. Each indicator has its advantages and country and predictions of future economic performance
disadvantages. The evaluation is based on application of the which would provide a basis to determine that country’s
Parabolic-SAR indicator for four currencies namely currency’s value. Emphasis is also placed on interest rate
EURUSD, GBPUSD, USDCHF and USDJPY individually to differentials between that country and other countries to arrive
identify effectiveness of the indicator regarding to the amount at a fair value of the currency, fundamentalist is an agent who
of profit generated, using hourly data of market stretch from trade by utilizing fundamental analysis [4].
January 2001 to December 2010. Virtual Historical Trading
Software (VHTS) is developed for the purpose of computing
the indicator based on its original formulas and 1.2. Technical Analysis in Forex
interpretations; for applying the assumptions; for trading Technical analysis (TA) or charting arrives at future currency
based on buy and sell signals generated by the Parabolic SAR price movements by using historical data generated by market
(P-SAR) indicator. and usually include price and volumes [5]. Although TA in
general has been used for more than hundred years, the field
Keywords: Forex, Parabolic SAR, Technical analysis, had received scant attention until recently by academicians
Fundamental Analysis, Indicator who had been more focused on fundamental approaches [6-8].
There are two main analytical concepts for TA; quantitative
and qualitative. The quantitative- based analysis attempts to
1. Introduction generate indicators such as MACD and P-SAR while the
Trading in foreign currencies began in 1973 following the qualitative-based analysis relies on elucidation of the shape of
collapse of the Bretton Woods agreement under which gold geometric patterns like levels of support and resistance and
held by central banks underpinned currency values. Forex is a double bottoms[7]. Successful TA is built on these three
free market in which currency prices are based on supply of essential principles [1]:
and demand for a particular currency [1].
The Forex market has several distinct advantages over other
financial markets, such as: operation on a 24-hour basis 5 days 1.3. Profitability
a week, no fixed location, and an over-the-counter market. Many studies show that TA provides valuable financial
Besides, Forex market currently generates a daily volume of signals [8] and recent empirical studies also provide
over USD 3.2 trillion thereby making it the largest financial increasing support for TA. Furthermore, the following
market [2]. Any currency can be traded as long as there is no researchers agree with this fact; Sweeney (1986, 1988);
restriction by central banks issuing the currencies [3]. Ding et Brock, Lakonishok, and LeBaron (1992); Blume, Easley, and
al. (2010) added that rapid technological changes to increase O’Hara (1994) ; Neely, Weller, and Dittmar (1997); Chan,
efficiency in Forex transactions have enabled the market to Jegadeesh, and Lakonishok (1996, 1999); Gencay (1996,
grow at a tremendous pace by reducing entry and transaction 1998, 1999); Brown, Goetzmann, and Kumar (1998);
costs as well as overcoming geographical limitations. Rouwenhorst (1998); Neely and Weller (1999); Chang and
Osler (1999); Lo, Mamaysky, and Wang (2000); Chan,
Hameed, and Tong (2000); and Hsu and Kuan (2004) [9-18].
Their findings imply the popularity of TA over FA is due to for market participants. Relative Strength
the fact that the former can “beat the market”. Index (RSI), Stochastic Oscillator (STOCH) and Williams’
Moreover, (Papadamou and Tsopoglou, 2001) indicated that %R are some example of Momentum Indicators.
TA approach can generate higher profit against a simple “buy
and hold” strategy which is a fundamental analysis [19]. They
have assessed USDDEM and USDGBP in their study for 2.5. Function of Indicators
about 8 years from 1989 to 1996 to find out whether TA is Thus, there are many indicators in market with different
profitable. Also, according to Lui (1998), more than 85% of formula and usage. The main function of them is giving signal
Forex traders in Hong Kong using both fundamental and to enter; open the buy or sell orders, and exit; close the opened
technical analysis together to forecast future price movements orders from market. Since, finding the optimum point of price
but they believe TA is more useful in predicting trends than to buy or sell is the main concern of traders, indicators are
FA [20]. trying to solve this problem and they are used to find the best
point of price for buying or selling. There are several
indicators which are more popular among traders such as
2. Indicators Moving Averages; Bollinger Bands; Relative Strength Index
Indicators are mathematical computations based on currencies (RSI); P-SAR (Stop And Reverse); Moving Average
data such as volume and prices (opening, low, high and Convergence/Divergence (MACD); and Stochastic Oscillator.
closing) with a specific formula. The value of result is used to
forecast upcoming changes in prices. They are used to provide
clearer and extra information about market to be used by 3. P-SAR
investors to make better decisions. Indicators are classified to The P-SAR first introduced in 1978 by Welles Wilder, Jr. in
four main categories based on their functions; trend indicators, his book, “New Concepts in Technical Trading Systems”. The
volume (strength) indicators, volatility indicators and components of P-SAR are time and price. The expression of
momentum indicators as follow [5]. “parabolic” is used in the P-SAR because when run for a chart
make a parabola with a string which made by spots. In
addition to that, “Stop and Reverse” abbreviated to “SAR”
2.1. Trend Indicators which is the main characteristic of this indicator; when
Trend is a term used to explain the persistence of exchange- touched by price, it stops the present parabola and reverses the
rate movement over time in one direction. There are three dots to make another one. Calculation of P-SAR is easy,
directions for trends; sideways, down and up. Trend indicators although it is complicated. LO SIP stands for low significant
level variable rate data to generate a combination of market point while HO SIP stands for high significant point in a SAR
direction. Moving Averages (MA), MACD, P-SAR and Trend cycle. The first point in each SAR cycle equals to either the
lines are some example of Trend Indicators. LO SIP or HI SIP of the previous SAR cycle so that the value
of starting point of each SAR cycle equals to LO SIP when
downward P-SAR reverses to upward, and vice versa as given
2.2. Volume (Strength) Indicators in Equation 1.
Market strength illustrates the market attitude intensity with
reference to a rate by inspecting the market positions in use by SAR1 = LO SIPPrevious or HI SIPPrevious
a variety of buyers and sellers. The basic data to compute (Eq. 1)
these indicators is volume. Their hints for buyers and sellers
are coincident or leading the market. Volume, Money Flow Besides, Upward and Downward SAR are calculated
Index (MFI), On-balance volume (OBV) and Force Index (FI) according to the aforesaid factors differently as given in
are some example of Volume Indicators. Equations 2 and 3. Note that for calculating the value of the
rest of the SAR cycle (not the first point), SIP is determined
by checking the same SAR pattern with respect to the SAR
2.3. Volatility Indicators situation; upward or downward.
Volatility is a common term used to explain the size or
magnitude of tick-to-tick price oscillation independent of their Upward: SARCurrent = SARPrevious + AF (LO SIPPrevious –
trend direction. By and large, variations in volatility tend to SARPrevious) (Eq 2)
direct variations in prices. Average True
Range (ATR), Bollinger Bands (BB) and Standard
Downward: SARCurrent = SARPrevious – AF (SARPrevious – HI
deviation (σ) are some example of Volatility Indicators.
SIPPrevious) (Eq 3)

2.4. Momentum Indicators As can be seen in Figure 1, every time the price contacts the
Momentum is a general term used to illustrate the rapidity at SAR, it reverses to the converse trend telling an entry signal
which rates move over a particular time period. Momentum opposed to the previous trade.
indicators specify the weakness or strength of a trend as it
grows over time. Momentum indicators provide clear signals
 • Creates and objective trading environment
• Clear signals
• Great for exits

4. Scope of the Study

The data used in this study are real and worldwide some
which are selected within the scope of this study; trading on
hourly basis and for 10 years starting from January 2001 until
December 2010. The hourly data for ten years makes it huge
with more transaction to have reliable results. This study is
Figure1: SIP points in a SAR cycle conducted to evaluate the one main indicator for predicting the
market in order to buy or sell on the right time to gain profit
AF; acceleration factor, starts at 0.02 and whenever the SIP and avoid lose.
varies in a cycle of Parabolic SAR, the new AF calculated by Four currencies; EURUSD, GBPUSD, USDJPY, USDCHF
adding 0.02 to the previous AF while AF does not exceed are evaluated with the employment of P-SAR at which buy
0.20. These assumptions are default and could be adjusted by and sell signals are identified. Period of the study is ten years
traders [21]. starting from January 2001.
To avoid the effects of one indicator on the other’s result, the
currencies evaluated separately. It means for each currency,
3.1. PSAR Critical factors indicator applied and evaluated separately; so there are one
The critical factors of P-SAR are time and price. P-SAR gives indicator and four currencies and combination of them are
clear signals to traders and its interpretation is so simple and four cases which are called traders. Thus, there are four virtual
easy. Whenever the P-SAR changes its direction, a signal is traders that each one working just with the indicator and
generated as shown in Figure 4. In this study, if the value of currency.
SAR is downward in the first hour and reverses the direction
to upward in second period, there is a buy signal in third hour.
In addition to that, if the direction changes from upward to 5. Methodology, Data Acquisition and Assumptions
downward the signal is considered the sell signal [21]. The research areas on this project are based on the preface and
literature review prior this chapter. This chapter will outline
the research design for this project and the way in which the
research was accomplished. The methodology as presented in
Figure 2 has been adopted in order to meet the objectives of
this study.
Data types required for the current study are hourly opening,
high, low, closing prices and trade volume for four currencies
within 24 hours a day of weekdays from January 2001 to
December 2010. The data are obtained from online data base
of Foreign Exchange Market on MetaTrader software.
Figure 4: Buy and sell signal from P-SAR indicator

3.2. P-SAR advantages and Properties

P-SAR is not useful for short term fluctuations in a choppy
market but it is useful over real trends lasting several hours or
days. This indicator helps to maximize profits with free forex
charts. Also, the P-SAR is more capable in whipsaws in the
market and it can generate a large volume of losing signals in
the stock with trading sideways (up and down rapidly). It
means, this indicator works very well for buying and selling in
trending markets only.
One of the other benefits of this indicator is the mechanical
nature of the signals given with little to no interpretation Figure 2: The research process flow diagram
necessary. Dislike to most of the technical analysis tools, it is
unambiguous and clear in the signals given. The data from this online data base are exported into the
Totally, we can highlight four major attributes and properties spreadsheets including over 60,000 rows for each currency;
for P-SAR indicator namely: frequency is hourly (period 2001-2010). An example of the
• Good for trending markets data on MetaTrader software is shown in Figure 3. After
compiling the data, they are analyzed and processed. It covers as shown in Table 1. However, the results are different for
the first research question: what are the volume and open, each currency; it is considerable that the circumstances of all
high, low and close prices for each currency in hourly basis currencies for using P-SAR are the same; trading with the
for the years 2001 -2010. same assumptions and interpretations. Moreover, the results
indicate that P-SAR is not a suitable indicator for these
currencies with applying its interpretations considering this
study’s assumptions. However, application of P-SAR for
EURUSD is the most profitable result compared to other
currencies since it generated 1459 pips profit. Although, this
profit could not increase the capital a lot due to time which it
is created.
Table 1 demonstrates results of implementing P-SAR for four
different pair-currencies which are shown in four separate
columns. First three rows are showing produced profit that is
split to two parts, sell and buy profit. The same thing is
displayed for loss in second three rows. The third three rows
are demonstrating total profit/loss and its sell and buy
Figure 3: An example of the data on MetaTrader software division. Fourth three rows are showing the number of sell
and buy transactions and total number of transactions for each
MetaTrader is one of the key tools for this study. It is Forex pair-currency. Finally, the last three rows are displaying
trading online software which widely used by foreign ending balance, last trading date and paid commission to
exchange traders. The traders can sell or buy via this online broker.
software. To provide facility for traders, MetaTrader generates The following assumptions are considered in this study in
the graphs and charts of the indicator based on live and order to unification the twenty traders’ condition. With the
historical data. employment of these assumptions, each trader will be isolated
The other tool is used for analysis and processing the data, is from everything that can deflect the results. These
Microsoft Excel software. Since the data are wide and assumptions have been chosen based on researcher’
calculations are based on each item, Virtual Historical Trader experiences in Forex market and studying Forex market,
Software (VHTS) is developed based on Microsoft Excel to capital management and risk management to make the result
apply assumptions and trade based on them on historical data. comparable and unified.
Moreover, to cover the lack of Microsoft Excel formulas and • Trading period is ten years starting from 1st January of
to increase accuracy of calculations, TA-Lib program is added 2001. It is because for less than ten years period the results
to Excel. It is a program which adds indicator’s formulas to are not reliable and useful. In addition, more than that the
Microsoft Excel function list. data become huge and difficult to process them and out of
VHTS is developed for application of assumptions in order to scope of this study.
create a virtual circumstance for investors to trade like real • Traders can only trade one of the four pair currencies which
trading on historical data considering the assumptions. VHTS are EUR/USD, GBP/USD, USD/JPY and USD/CHF. These
has ability to calculate indicator for each row or period of currencies are chosen because according to Oh (2007)
spreadsheet based on given data. Besides, it can open and European, North American and Japan Forex market
close sell and buy orders based on assumptions and signals efficiency is higher than the other foreign exchange market
created by indicator. Finally, it can calculate profit/loss for all and it helps to eliminate effects of other variables on results.
and each order. • Traders cannot open more than one position at the same
Empirical method has been applied for evaluating the time and upon a new order, the pervious order would be
profitability of using SAR indicator applied on four closed if still is open.
currencies. After collecting historical data from Meta Trader • Take profit (TP) and stop loss (SL) for each order is 30
software the data are assessed to make sure they are the pips. It reduces the risk of losing big amount and of course
required data. The assessed data are used to calculate makes the profits small too.
indicator. This indicator is calculated in VHTS with its unique • The volume of order cannot be more than 7% of the traders’
formula which is explained and default assumptions suggested capital balance. This assumption is to reduce lack of capital
by its inventor. To prevent any error and mistake in VHTS, all risk when the fluctuation and volatility are high.
formulas and assumptions have been rechecked and the
• Initial capital for each trader is $10,000
software has been run several times to make sure that the
• Trading time is 24 hours and 5 days a week and upon
results are correct and reliable. It covers the second research
receive the buy or sale signal from the P-SAR
question: what are the hourly values of the selected indicators
for each currency. • If a position do not reach to its level of take profit or stop
loss and there is no new order, the order will be closed
automatically after 10 periods (hours) and profit/loss is
calculated based on the last 10 hours.
6. Data Collection and Assumptions
After computing and interpretation the data, from 2001 till • There is no limitation in amount of each order since it is 7%
2010, based on P-SAR indicator, VHTS generated the results of the capital balance.
• Minimum order is 0.01 of the lot The ordering did not stop during 10 years period of this study
which show the capital could reach to end of project.
Table 1: Summary of the final outcomes using P-SAR indicator and Moreover, the total profit generated by buy orders is 1893
its related interpretations for the years 2001 to 2010 pips which is resulted from 34173 pips profit and 32280 pips
loss while the total loss created by sell orders is 434 pips
Indicator

which is resulted from 33344 pips profit and 33778 pips loss.
Parabolic SAR The 1459 pips profit generated by 434 pips loss from sell
transactions and 1893 pips profit from buy orders. Application
of P-SAR for EURUSD is more effective compared to other
three currencies in term of high profitability.
EURUSD

USDCHF
GBPUSD

USDJPY
Currency

Table 2: Yearly outcome of EURUSD trading using P-SAR indicator

Profit/ Loss Profit/ Loss Profit/
Year
Sell Profit (pip) 33,344 22,173 15,065 29,973 Buy Sell Loss
Buy Profit (pip) 34,173 23,275 17,368 28,810 2001 (183) 424
Total Profit (pip) 67,517 45,448 32,433 58,783
241
Sell Loss (pip) (33,778) (25,863) (19,517) (28,912) 2002 265 (946) (681)
Buy Loss (pip) (32,280) (24,659) (17,345) (29,302)
Total Loss (pip) (66,058) (50,522) (36,862) (58,214) 2003 277 646 923
Profit/Loss (pip) 1,459 (5,074) (4,429) 569
Profit/Loss Sell (pip) (434) (3,690) (4,452) 1,061 2004 624 (514) 110
Profit/Loss Buy (pip) 1,893 (1,384) 23 (492)
Buy counter 2,470 1,683 1,182 2,205
2005 (53) 766 713
Sell counter 2,497 1,692 1,196 2,228 2006 (846) (71)
Total Orders 4,967 3,375 2,378 4,433
(917)
Ending Balance 10,715.06 142.95 141.73 4,590.59 2007 (2) (361) (363)
Date of Closing
2010.12.31 2007.08.07 2005.07.21 2010.12.31
Trader 2008 387 (25) 362
2009 1,255 (621) 634

7. Process 2010 169 268 437

Results and discussion is presented according to the research Total 1,893 (434) 1,459
methodology format: data collection and assessing; data
processing; calculating the P-SAR with the aid of Virtual
The more detail results of using this indicator for EURUSD is
Historical Trading Software (VHTS). Then buy and sell
given in Table 2 and as it is clear from the Table, 1459 pips
signals from interpretations of the indicator for the four
profit created within first 10 years. It indicates that even
currencies EURUSD, GBPUSD, USDCHF and USDJPY have
though in most of the year buy and sell signal made loss but
been determined. After that, the trading software based on the
the generated profits were enough to cover losses and result an
assumptions has been run to obtain profit/loss of each
overall profit.
currency regarded to application of the indicator, so there are
four virtual traders.
7.2. GBPUSD
There are 3375 transactions including 1683 buy and 1692 sell
7.1. EURUSD
orders which are created by employment of P-SAR indicator
With the employment of P-SAR for EURUSD in order to
for GBPUSD that continued trading until 2007 August. Total
identifying the signals to enter and exit the market, 4967
numbers of buy and sell of GBPUSD with the employment of
orders include 2470 buy orders and 2497 sell orders has been
P-SAR indicator during seven years (2001-2007) is presented
proceeded. Total numbers of buy and sell of EURUSD with
in Figure 6.
the employment of P-SAR indicator during ten years (2001-
2010) is presented in Figure 5.

Figure 6: Final percentage of GBPUSD buy and sell using P-SAR

indicator for the years 2001 to 2007
Figure 5: Final percentage of EURUSD buy and sell using P-SAR
indicator for the years 2001 to 2010 As a result of those transactions 5074 pips loss has been made
which included 45448 pips profit and 50522 pips loss. In other
word, 3690 pips loss of sell transactions and 1384 pips loss of Profit/Loss Profit/Loss Profit
buy transactions created 5074 pips total loss within seven Year
Buy Sell /Loss
years. The 3690 pips loss which created by sell transactions 2001 (5) (1,169) (1,174)
included 22177 pips profit and 25863 pips loss. While, the
1384 pips loss generated by buy orders included 23275 pips 2002 (163) (832) (995)
profit and 24659 pips loss. 2003 (232) (815) (1,047)
Yearly details of profit and loss using the foresaid indicator
2004 488 (713) (225)
for GBPUSD are presented in Table 3. The table shows the
progress of the 5074 pips loss production within seven years. 2005 (65) (923) (988)
As it is clear in Table 3, both sell and buy signals created loss Total 23 (4,452) (4,429)
however the loss generated by sell signal is almost triple of
buy signals’ loss.
As it can be seen in Table 4 all transactions created loss
Table 3: Yearly outcome of GBPUSD trading using P-SAR indicator
during the five years period of trading except buy orders in
2004 which made profit and it was enough to cover all loss of
Profit/Loss Profit/Loss Profit/
Year
Buy Sell Loss buy signals and generate overall profit for buy orders.
2001 (781) 520 (261)
2002 (175) (707) (882) 7.4. USDJPY
2003 463 (982) (519)
P-SAR signals for USDJPY results 569 pips profit which
included 58783 pips profit against 58214 pips loss and the
2004 110 (628) (518) trading period did not last within the ten years. This 569 pips
2005 (947) (1,086) (2,033) profit contained 1061 pips profit from sell transactions and
2006 189 (330) 492 pips loss from buy transactions. There are 2228 sell
(141)
orders and 2205 buy orders generated by P-SAR
2007 (243) (477) (720)
interpretations. Total numbers of buy and sell of USDJPY
Total (1,384) (3,690) (5,074) with the employment of P-SAR indicator during ten years
(2001-2010) is presented in Figure 8.
7.3. USDCHF
With the implement of P-SAR for USDCHF in order to
discovering the signals to buy and sell the market, 2378 orders
include 1182 buy orders and 1196 sell orders has been
proceeded. Total numbers of buy and sell of USDCHF with
the employment of P-SAR indicator during five years (2001-
2005) is presented in Figure 7.

Figure 8: Final percentage of USDJPY buy and sell using P-SAR

indicator for the years 2001 to 2010

Moreover, these sell orders made 1061 pips profit which

includes 29973 pips profit and 28912 pips loss while buy
transactions generated 492 pips loss which includes 28810
pips profit and 29302 pips loss. Table 5 showing the yearly
details of buy and sell transactions, demonstrates that the sell
orders worked better than the buy orders and there is overall
Figure 7: Final percentage of USDCHF buy and sell using P-SAR
indicator for the years 2001 to 2005 profit for sell transactions that could cover buy orders’ loss.
The ordering stopped after five years since the capital was not However, buy transactions generate profit in five years but it
enough to continue the trading. It means trading with P-SAR was not enough to cover the loss and there is overall 492 pips
results loss more than profit and it caused decreasing capital loss for buy orders.
while the time is passing. Moreover, the total profit created by
Table 5: Yearly outcome of USDJPY trading using P-SAR indicator
buy orders is only 23 pips which is resulted from 17368 pips
profit and 17345 pips loss while the total loss created by sell Profit/Loss Profit/Loss
Year
orders is 4452 pips which is resulted from 15065 pips profit Buy Sell Profit/Loss
and 19517 pips loss. Finally, there are 4429 pips loss created 2001 (323) (196) (519)
by sell and buy orders from 32433 pips profit and 36862 pips 2002 (342) 256 (86)
loss.
2003 (285) 650 365
Table 4: Yearly outcome of USDCHF trading using P-SAR indicator 2004 28 (84) (56)
 2005 628 (288) 340 capital management and risk management to make the result
comparable and unify. The following findings have been
2006 730 (894) (164) obtained from the current study:
2007 322 23 345 • The most effective combination of P-SAR-Currency
2008 (918) 326 (592) regarding generation of profit has been identified to be P-
SAR-EURUSD with considering the assumptions of this
2009 (371) 720 349
study. P-SAR performed well with EURUSD as it has
2010 39 548 587 created $10,715.06 cash at the end of ten years period of
Total (492) 1,061 569 trading (Table 1).
• The other finding was that the total profit generated by buy
signals for all four traders is 40 pips however sell signals
generate 7,515 pips loss which the difference
8. Analysis is considerable. It shows P-SAR produces more profitable
Final profit/loss of all four currencies trading with the buy signals than sell signals.
employment of P-SAR indicator for the period of ten years
(2001-2010) is presented in Figure 9. ACKNOWLEDGE
The special thanks go to our advisor Dr. Arash Habibi
Lashkari for his guidance and advices in this project.

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