Description and methodology
The Parabolic SAR indicator was developed by Welles Wieder, who is the father of the RSI and DMI indicators as well. The indicator defines stop prices for the investor’s short and long positions. This is where the stop-and-reversal (SAR) name came from. SAR is used to define the stops rather than to recognise trends and their direction. The calculation may seem complicated, but the results are simple to interpret. Results below the price indicate stops for long positions and results above the price indicate stops for short positions. It has two settings: step and maximum step. The higher the step the more sensitive the indicator to price changes. When the step is calibrated too high, the indicator will fluctuate rapidly which makes the decision-making more difficult. The recommended settings are the following: 0.02 for step and 0.2 for maximum step.
- Buying stock:
[latex]SAR_{i}=SAR_{i-1}+AF_{i}\times (High_{i}-SAR_{i-1})[/latex]
- Selling stock:
[latex]SAR_{i}=SAR_{i-1}+AF_{i}\times (Low_{i}-SAR_{i-1})[/latex]
When the share price reaches minimums or maximums, the value of AF will increase accordingly to the step amount. The barrier of this increase is the recommended maximum step (0.2). The calculation is restarted every time when the share prices exceeds the SAR level. If Extreme indicates one of the two extremes of the closing price, then:
Parabolic SAR calculation formulas
Trading signals
Wilder recommends to first recognise the trend and only after that step should the trading start with the SAR indicator (in the trend’s direction):
- In case of an ascending trend, the indicator shows buy signal when its value sinks below the share price.
- In case of a descending trend, the indicator shows sell signal when its value rises above the share price.
Use
Parabolic SAR works the best on markets with strong trends. Thus, the investor should trade on such markets. Wilder’s ADX line helps to recognise these markets.
Examples
The Parabolic SAR has given correct sell and buy signals for most of the trends in the example below. Long positions should be closed when prices drop below the SAR (red arrow) and short positions should be closed when prices rise above the SAR (green arrow). The settings recommended by Wilder reduce the fluctuations, but cannot fully exclude false signals when the prices move rapidly (black arrow).
Parabolic Stop and Reverse points
