The Parabolic Stop-and-Reversal (SAR) indicator, developed by Welles Wilder, sets trailing price stops for long or short positions. The indicator appears as dotted lines above or below the price action. The SAR on top of the prices indicates a short position, whereas when the SAR is below the prices, a long position should be in place. However, a trend should be established first before entering into any position.
At the beginning of the move, the Parabolic SAR will have a wider gap between the price and the trailing stop. The gap will gradually diminish, thus making for a tighter stop-loss value as the price moves in the direction of the prevailing trend. However, note that the SAR will move upward (downward) every period if the position is long (short) regardless of the direction of the price action. When the price intersects the SAR, a reversal is imminent and the position should be reversed, as the indicator’s name implies.
The formula for the SAR is complex. The following steps are used to calculate the SAR:
There are two input parameters to the Parabolic SAR:
The Acceleration Factor, or step size, which starts at 0.02 and increases by 0.02 with each step to a maximum of 0.20. The higher the step is set, the more sensitive the indicator will be to price fluctuations. If the step is set too high, the indicator will fluctuate above and below the price too frequently, making analysis difficult.
The Acceleration Limit, or the maximum value the SAR can reach. Welles Wilder recommends a maximum acceleration limit of 0.20 for most financial instruments.
The SAR is an upper technical study. ProSticks uses default parameters of 0.02 and 0.20 for the acceleration factor and acceleration limit, respectively.
Wilder recommends using this study with the Directional Movement Index, or ADX, which can assist in determining the strengths of trends.