What is Parabolic SAR?
In short: The SAR or stop-reverse-system determines the direction of the stockprice ahead of time.
The Parabolic SAR is a technical indicator developed by J. Welles Wilder to determine the direction that an asset is moving. The indicator is also referred to as a stop and reverse system, which is abbreviated as SAR. It aims to identify potential reversals in the price movement of traded assets. It can also be used to provide entry and exit points.
The Parabolic SAR mainly works in trending markets. Wilder recommends traders should first establish the direction of the trend using the parabolic SAR and then use alternative indicators to measure the strength of the trend.
When graphically plotted on a chart, the Parabolic SAR indicator is displayed as a series of dots. If it appears below the current price, the parabolic SAR is interpreted as a bullish signal. When it is positioned above the current price, it is deemed to be a bearish signal. The signals are used to set stop losses and profit targets.
How Parabolic SAR works
The Parabolic SAR is usually represented in the stockchart as series of dots placed near the price bars. Normaly, when these dots are located above the price, it signals a downward trend and it is supposed to be a sell signal. When the dots move below the price, it shows that the trend of the stockpirce is upward and signals a buy.
The change in the direction of the dots produces trade signals which can produce a profit when the price makes big swings. However, the indicator is not as reliable in a flat or ranging market.
Developed by Welles Wilder, the Parabolic SAR refers to a price-and-time-based trading system. Wilder called this the “Parabolic Time/Price System.” SAR stands for “stop and reverse,” which is the actual indicator used in the system. SAR trails price as the trend extends over time. The indicator is below prices as they’re rising and above prices as they’re falling. In this regard, the indicator stops and reverses when the price trend reverses and breaks above or below the indicator.
Wilder introduced the Parabolic Time/Price System in his 1978 book New Concepts in Technical Trading Systems. This book also includes RSI, Average True Range (ATR), and the Directional Movement Concept (ADX). Despite being developed before the computer age, Wilder’s indicators have stood the test of time and remain extremely popular.
The Parabolic SAR works best with trending securities, which occur roughly 30% of the time according to Wilder’s estimates. This means the indicator will be prone to whipsaws over 50% of the time or when a security is not trending. After all, SAR is designed to catch the trend and follow it like a trailing stop. As with most indicators, the signal quality depends on the settings and the characteristics of the underlying security. The right settings combined with decent trends can produce a great trading system. The wrong settings will result in whipsaws, losses, and frustration. There is no golden rule or one-size-fits-all setting. Each security should be evaluated based on its own characteristics. Parabolic SAR should also be used in conjunction with other indicators and technical analysis techniques. For example, Wilder’s Average Directional Index can be used to estimate the strength of the trend before considering signals.
From: Fidelity.com “PSAR”