Parabolic SAR & Heikin-Ashi Candles

Identifying trends and filtering out market noise is key to successful technical analysis trading. Two popular tools that help traders achieve this are the Parabolic SAR (Stop and Reverse) and Heikin-Ashi Candles. Both indicators are trend-following tools, but they serve different purposes. The Parabolic SAR helps traders spot trend reversals and determine entry and exit points. At the same time, Heikin-Ashi Candles provide a smoothed representation of price action, making it easier to visualise the overall trend.

In this article, we’ll explore how the Parabolic SAR and Heikin-Ashi Candles work, how traders interpret them, and how they can be combined to create more effective trend-following strategies.

What Is the Parabolic SAR?

The Parabolic SAR (Stop and Reverse) is a technical indicator developed by J. Welles Wilder that helps traders identify potential trend reversals. The indicator is represented by a series of dots that appear above or below the price, depending on the trend.

• When the dots are below the price, it signals a bullish trend.
• When the dots are above the price, it signals a bearish trend.

The Parabolic SAR is primarily used to determine exit points in trending markets. It acts as a trailing stop-loss and helps traders lock in profits as the price moves in their favour. When the trend changes direction, the indicator “stops” and “reverses,” providing a signal to exit the current position or even enter a new position in the opposite direction.

Image Courtesy: Tradingview

How the Parabolic SAR Works

The dots in the Parabolic SAR follow the price action at an accelerating pace. As the trend continues, the dots move closer to the price, eventually triggering a reversal signal when the price crosses the dots. The formula for Parabolic SAR involves the Acceleration Factor (AF), which increases as the trend gains momentum, causing the dots to catch up to the price faster.

• The AF starts at 0.02 and can increase to a maximum of 0.20 as the trend continues.
  
• The faster the trend, the quicker the SAR reacts.
  

How to Interpret the Parabolic SAR

The Parabolic SAR is best used in trending markets and provides clear signals for traders to enter or exit trades. Here’s how traders interpret it:

1. Entry and Exit Signals

• Bullish Signal: When the dots flip below the price, it indicates the beginning of a bullish trend, signalling traders to buy or hold their long positions.

• Bearish Signal: When the dots flip above the price, it indicates the start of a bearish trend, signalling traders to sell or exit long positions.

2. Using Parabolic SAR for Trailing Stop-Loss

One key benefit of the Parabolic SAR is its ability to act as a trailing stop-loss. As the trend continues, traders can use the dots as a dynamic stop-loss level, helping them protect profits while staying in the trade until the trend reverses.

3. Avoiding Choppy Markets

The Parabolic SAR works best in trending markets. In sideways or choppy markets, it can give false signals due to frequent trend changes. Therefore, traders often combine it with other indicators, like Moving Averages or RSI, to confirm the trend before acting on the Parabolic SAR signals.

What Are Heikin-Ashi Candles?

Heikin-Ashi Candles is a type of candlestick chart that provides a smoothed representation of price action. Unlike traditional candlesticks, Heikin-Ashi Candles uses a modified formula to calculate each candle’s open, closed, high, and low prices. This results in a chart that filters out market noise, making it easier to identify the overall trend.

The formula for Heikin-Ashi Candles is as follows:

• Close = (Open + High + Low + Close) / 4
• Open = (Previous Open + Previous Close) / 2
• High = The highest of the High, Open, or Close values.
• Low = The lowest of the Low, Open, or Close values.

Image Courtesy: Tradingview

How Heikin-Ashi Works

Heikin-Ashi Candles smooth out price data, making trends easier to spot. Unlike traditional candlesticks, they tend to form more consecutive series of green (bullish) or red (bearish) candles, helping traders stay in trends longer.

• Bullish Candles: Long bodies with no lower wicks suggest a strong uptrend.
  
• Bearish Candles: Long bodies with no upper wicks indicate a strong downtrend.
  

How to Interpret Heikin-Ashi Candles

Heikin-Ashi Candles make identifying trend reversals and continuations easier due to their smoothing effect. Here’s how traders interpret them:

1. Identifying Trends

• Bullish Trend: A series of green candles with long bodies and no lower shadows typically indicates a strong uptrend.
  
• Bearish Trend: A series of red candles with long bodies and no upper shadows signals a strong downtrend.
  

2. Spotting Reversals

• Doji-like Candles: Small bodies with both upper and lower shadows may signal a reversal or consolidation, indicating that the current trend is losing momentum.

3. Staying in Trends Longer

Heikin-Ashi Candles filter out short-term fluctuations, allowing traders to stay in trends longer without being shaken out by market noise. This makes them particularly useful for swing traders and position traders looking to capitalise on extended market moves.

How Traders Use Parabolic SAR and Heikin-Ashi Together

Traders often use the Parabolic SAR and Heikin-Ashi Candles together to create more reliable trend-following strategies. Here’s how they complement each other:

1. Trend Confirmation

• Traders can use Heikin-Ashi Candles to confirm the strength and direction of a trend. If Heikin-Ashi shows a strong series of green candles and the Parabolic SAR is below the price, it confirms a bullish trend.

• Similarly, if Heikin-Ashi shows a series of red candles and the Parabolic SAR is above the price, it confirms a bearish trend.

2. Combination to get Entry and Exit Signals

• Entry: When Heikin-Ashi Candles turn green after a series of red candles, signalling a trend reversal, and the Parabolic SAR flips below the price, it could signal a buying opportunity.

• Exit: When the Parabolic SAR flips above the price and Heikin-Ashi Candles turn red, it signals an exit from long positions or a potential short trade.

3. Filtering Out False Signals

• The Heikin-Ashi Candles smooth out price action and help filter out false signals that the Parabolic SAR might generate in choppy markets. Using both tools, traders can avoid whipsaws and only act when both indicators confirm the trend.

Example: Using Parabolic SAR and Heikin-Ashi in HDFC Bank

Image Courtesy: Tradingview

Let’s take HDFC Bank as an example. Suppose the price has been in an uptrend, and Heikin-Ashi Candles shows a series of green candles with no lower wicks. At the same time, the Parabolic SAR is below the price, confirming the uptrend. As the price continues to rise, traders can use the Parabolic SAR dots as a trailing stop-loss, staying in the trade until the Parabolic SAR flips above the price and Heikin-Ashi Candles turn red, signalling a reversal.

Common Mistakes to Avoid

While both Parabolic SAR and Heikin-Ashi are powerful tools, traders should be cautious about potential pitfalls:

• Overreliance on Parabolic SAR in Range Markets: The Parabolic SAR performs best in trending markets. In sideways markets, it can give false signals. Traders should confirm the trend with other indicators, such as Heikin-Ashi, before acting on SAR signals.

• Ignoring Reversal Candles in Heikin-Ashi: Traders should pay attention to doji-like Heikin-Ashi Candles that signal a possible reversal. Ignoring these signals can lead to missed opportunities.

• Not Combining with Other Indicators: Parabolic SAR and Heikin-Ashi work best when used together or alongside other indicators like RSI or Moving Averages to confirm the strength and direction of the trend.

Conclusion

The Parabolic SAR and Heikin-Ashi Candles are valuable tools for identifying trends, spotting reversals, and managing trades. While the Parabolic SAR excels in pinpointing entry and exit points, Heikin-Ashi Candles provides a clearer picture of the overall trend by smoothing out price action. These tools can help traders navigate trending markets with greater confidence.

In the next chapter, we will explore few essential Volatility Indicators, which help traders understand market fluctuations and price behaviour.