Understanding Parabolic SAR

In the field of Technical Analysis, Parabolic SAR (SAR is an acronym for Stop and Reverse) is a method developed by the famous technician J. Welles Wilder, Jr, to determine trends in market prices or securities and it is shown as a series of dots placed either above or below an asset's price on a chart. It may be employed as a trailing stop loss based on prices tending to remain within a parabolic curve during a strong trend.

The parabolic SAR is a technical indicator that is used by many traders to find out the direction of an asset's momentum and the point in time when this momentum has a higher-than-normal probability of switching directions.

The concept draws on the idea that time is an enemy, and unless a security can continue to generate more profits over time, then it should be liquidated. The Parabolic SAR generally works well in trending markets. However, it provides "whipsaws" during non-trending, sideways phases and as such, Wilder recommended establishing the strength and direction of the trend first through the use of methods such as the Average Directional Index, and subsequently using the Parabolic SAR to trade that trend.

A parabola below the price is generally bullish, while that above the price is generally bearish.

Calculation

The Parabolic SAR is calculated almost independently for every trend in the price. For an uptrend price, the SAR appears below the price and converges upwards towards it. In the same way, on a downtrend, the SAR appears above the price and converges downwards.

The SAR is calculated ahead of time at each step within a trend. The general formula used is:

SARn represents today's SAR values and
SARn + 1 represents tomorrow's SAR values.

The extreme point (EP) is a record kept during each trend that represents the highest value reached by the price during the current uptrend — or the lowest value during a downtrend. On each period, if a new maximum or minimum is observed, the EP is updated using that value.

α represents the acceleration factor. This is usually set to a value of 0.02 initially and increased by 0.02 each time a new EP is recorded. This means that each time a new EP is observed it will increase the acceleration factor. This will then increase the rate at which the SAR converges towards the price. To keep it from getting too large, a maximum value for the acceleration factor is normally fixed at 0.20, so that it never exceeds this value. For stocks trading, it is preferable to set the acceleration factor to 0.01, so as to be less sensitive to local decreases. For commodity or currency trading, it is preferable to use a value of 0.02 for the acceleration factor.
In case a trend switch occurs, several things happen. The first SAR value for this new trend is set to the last extreme point (EP) recorded on the preceding trend. The EP is then reset accordingly to the maximum for this period. The acceleration factor is then reset to its initial value of 0.02.

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