What is the Stop and Reverse (SAR) Strategy?

In this article, we will discuss

• Beyond the Traditional Stop-Loss Limit
• The Stop and Reverse Strategy: An Introduction
• A Closer Look at How SAR Orders Work
• Using Moving Averages in Your SAR Strategy
• The Parabolic SAR (PSAR) Indicator
• Things to Keep in Mind Before Implementing this Strategy
• Conclusion

The primary goal of any trade in the securities market is to earn profits. While no trader will disagree with this, there is another goal that goes hand-in-hand with the first — and that is to limit or eliminate losses. This is why whenever you initiate a trade, you need to focus on the entry and exit price points as well as the stop-loss limit. While the exit price determines your profit, the stop-loss limit does exactly what it indicates — it helps limit your losses.

Beyond the Traditional Stop-Loss Limit

Consider a hypothetical scenario where a stock you are interested in is currently trading at Rs. 100. You expect the price of the stock to move upward, so you enter a long position and buy 100 shares in this company. To protect your money from any downside risk, you set a stop-loss at Rs. 95.

Now, say the price rises to Rs. 103 before falling steeply past Rs. 95. Since you had set this price as the point to exit in case of a loss, your trade will be closed and your loss will be limited to Rs. 5 per share (or Rs. 500 in total).

However, here is where the traditional method of stopping losses falls short. It helps curb the loss, but it does not allow you to take a new position to profit from the unexpected market movement. The Stop and Reverse (SAR) strategy bridges this gap by tackling both these aspects — namely, stopping losses as well as reversing your position.

The Stop and Reverse Strategy: An Introduction

A Stop and Reverse trading strategy involves stopping your losses by exiting your current position and simultaneously entering a reverse position in the market, so you can capitalise on the unfavourable market movement. You can rely on this strategy when technical indicators suggest that the ongoing price trend may be about to reverse. This will help you lock in your profits and minimise your losses before the trend changes.

For example, say you currently hold a long position in a stock whose price you expect will rise in the forthcoming trading sessions. However, the market trend reverses unexpectedly and the price of the stock begins to fall. This will mean that once the market price moves below your purchase price, you will start to incur losses.

If you have a SAR strategy in place, once the price hits the SAR price limit, your current position will be closed and a new short position will be opened at that price level. This short position allows you to bet on the new price trend (which is bearish in this case).

You can automate such trades so that when a certain price level is achieved, the SAR strategy is triggered and both the exit and the new entry are executed in quick succession.

A Closer Look at How SAR Orders Work

SAR orders work by setting a stop-loss level that closes the current position and immediately opens a new position in the opposite direction. The mechanism behind these orders is simple yet effective. When you expect a trend reversal, you can employ this strategy to benefit from the bullish-to-bearish transition (or vice versa).

These orders help you maintain your exposure to market movements without constant monitoring or manually entering and exiting trades. By adopting this approach, you will always have either a long or a short position open in the market. This means that no matter how the price is moving, you will be positioned to capitalise on that movement.

To make the stop and reverse strategy effective, you need to correctly interpret the market and set appropriate SAR trigger prices. Indicators like moving averages and the parabolic SAR (PSAR) can help you with this.

Using Moving Averages in Your SAR Strategy

Moving averages (MAs) filter out the noise and smooth out price action, so you can identify the direction of price movements more easily. You can use simple or exponential moving averages to get a better idea of when a trend is starting to change.

A common approach is to use a short-term and a long-term moving average to pinpoint potential trend changes. If the short-term MA cuts across the long-term MA from below to above, it may indicate a potential upward trend — prompting you to consider setting a SAR order to close an ongoing short position and establish a long position instead. Conversely, if the short-term MA cuts across the long-term MA from above to below, it may be a trigger for an incoming downward trend. Your SAR strategy in this case should involve closing a current long position and going short instead.

Another way to use moving averages in your SAR strategy is to measure the distance between the MA and the current price to identify trigger points for stopping and reversing your position. For instance, you could set a trigger level when the price moves a certain percentage away from the MA.

You could also use the slope of the moving average to anticipate trend shifts in the market. A flattening slope may be a sign that a trend is losing momentum — meaning it may be time to prepare for a reversal. A steeper slope may indicate that the current trend is strong, so you can delay the SAR trigger until you expect a reversal.

The Parabolic SAR (PSAR) Indicator

Another indicator commonly used to identify reversals and set triggers is the parabolic SAR (PSAR). It is plotted on price charts as a series of dots that appear above or below the price bars or candlesticks. In an upward trend, the dots appear below the bars and in a downward trend, they are placed above the bars.

For regular trades, PSAR indicator dots below the price bars indicate that you need to buy and hold, while dots above the bars indicate that you need to sell or take a short position. However, the PSAR indicator can also be crucial for the SAR trading strategy. Here’s how you can use the parabolic SAR to stop your ongoing position and reverse it.

• Identify the Trend Direction

To identify the trend direction and reversals, you need to track the placement of the PSAR dots and look for a change in their positions. A shift in the dots from above the price to below indicates a reversal from a bearish to a bullish trend. This means it may be a good time to close a short position and enter a long position. Conversely, a shift in the PSAR dots from below the price to above indicates a bearish reversal, so you can close an ongoing long position and enter a short trade.

• Set the SAR Trigger Price

The dots used in the PSAR indicator can also help you set the stop-loss price levels. Since the indicator’s position moves as the price changes, you can use it to set dynamic SAR trigger prices. For instance, if you are in a long position, placing a trigger at the level of the PSAR dot below the price can protect against sudden downward reversals. Similarly, for short positions, you can set the level as per the PSAR dot above the price.

Things to Keep in Mind Before Implementing this Strategy

The SAR trading technique can be beneficial in many ways. However, you need to be mindful of a few crucial things before you use the stop and reverse method to leverage price movements in the market. Here are some such important considerations.

• Market Volatility

The SAR strategy is typically most effective in markets where the current trend is steady and easy to discern. If the volatility is too high, it may lead to numerous false signals that can be hard to trade. So, if you plan to use a stop and reverse move, make sure that market volatility is not working against you. Too many erratic price movements can make SAR signals less effective.

• Risk Management

The SAR strategy involves repeated shifts from a long position to a short trade (or vice versa). This means you essentially trade trend reversals, which could occasionally be false signals. To avoid incurring unprecedented losses, you must focus on risk management and determine in advance how much of your capital you are willing to risk on any trade. This will help you identify how far the stop-loss should be from the entry point.

• Fees and Costs

Depending on the brokerage plan you have chosen, you may be charged for each trade you initiate in the market. When you use the stop/reverse method, you will invariably end up with frequent trades that could quickly lead to mounting trading costs, which may cut into your profits. So, ensure that you calculate the costs upfront and remain aware of the true net gains from your trades.

• Backtesting and Simulation

If you are a beginner, you may want a little more practice before you start using the SAR strategy live in the markets. Simulations can help you with this. Additionally, you also need to test the potential effectiveness of your strategy. Backtesting using historical data makes this possible. You can use this method to check how your SAR strategy would have performed in the past, identify areas of strength and failure and tweak it as needed.

• Commitment and Time

Stopping a trade and reversing your position is not a one-time exercise. To be successful at SAR trading, you need to constantly monitor the markets and be ready to reverse your position at the most opportune moment. This is a time-consuming process that requires significant commitment. So, the SAR strategy may only be suitable for you if you are an active trader. That said, trade automation can help bridge this gap.

• Compatibility with Your Trading Style

The SAR trading strategy may seem like a lucrative opportunity. However, before you adopt this technique, you must also assess if it aligns with your overall trading style and goals. For instance, if you are more comfortable with a set-and-forget type of trading style or if you prefer longer holding periods, the mechanics of stopping a trade and reversing your position may not be suitable for you.

• Prevailing Market Conditions

The success of a stop and reverse strategy also depends greatly on the prevailing market conditions. Ideally, you should adopt this approach in markets that have a clear trend — whether upward or downward. On the other hand, in sideways or range-bound markets, this strategy may produce false signals and limit your profits or amplify your losses. So, before you implement this strategy, evaluate the current market for its suitability.

• Emotional Preparedness

The very essence of the SAR strategy involves frequently switching between long and short positions based on your predefined stop-loss levels. This can be psychologically demanding, especially for beginners who may find it hard to remain emotionally detached from the price fluctuations in the market. To be successful at SAR trading, you need to be able to enter or exit a trade as needed without any hesitation.

• Use of Other Indicators

The usage of a stop-then-reverse order can be a complete strategy by itself. However, it never hurts to confirm market signals using other technical indicators. With these tools, you can evaluate trends better, identify potential reversals and filter out false signals and noise in the market. This will make your trades more accurate and well-informed, thereby increasing the chances of profitability.

Conclusion

The Stop and Reverse trading strategy is easy enough that even beginners can easily grasp its nuances and implement it. Now, with many leading trading platforms supporting SAR limits, every active trader can make use of this strategy to capitalise on price movements in the market irrespective of the direction of change.

However, before you make use of this technique, ensure that you have clearly defined trading goals and keep the pointers discussed in this article in mind. This will help you make the most of the SAR trading method and allow each position you take to be potentially profitable.

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