Parabolic SAR

Last modified 13:33, 5 Nov 2012

Parabolic Stop and Return (SAR)

Developed by J. Welles Wilder Jr, creator of RSI and DMI, the Parabolic SAR is a trend following system that can detect trends in either direction, sloping up to indicate rising prices and sloping down to indicate falling prices.

SAR is an abbreviation for Stop And Reverse, and the acceleration mechanism built into its algorithm causes it to curve into the price chart, hence the parabolic appearance.

Also known as a "reversal system", the point of intersection between the Parabolic SAR and the price chart can be used to set trailing price stops for long or short positions. In fact, the Parabolic SAR is more popular for setting stops than for establishing direction or trend. Wilder recommended establishing the trend first, and then trading with Parabolic SAR in the direction of the trend. If the trend is up, buy when the indicator reverses and moves below the price. The built-in accelerator allows the trend to develop and establish itself, and then will curve in and intersect with the price chart soon after the trend reverses, at this stop point a trade can be entered or exited. If the trend is down, sell when the indicator moves above the price.

Calculation and Display

The formula is quite complex and beyond the scope of this definition, but the following explanation will describe the basic result.

The most basic concept is that when the dotted Parabolic SAR line touches the price chart, it will reverse (see intersection points on the example below).

When a trend reverses, the new Parabolic SAR, represented by a line of dots (orange), will commences at the lowest/highest point of the previous trend period (see starting levels, below).

parabolsarwords.gif

The dotted lines below the price chart form a parabola that will intersect with the price chart at the trailing stop for a long position, and the lines above the price chart will intersect (and thereby establish the trailing stop) for a short position.

At the beginning of the move, the rate of acceleration is low, this will provide a greater initial cushion between the price and the SAR Parabola. This allows the trend to become established. As the move gets underway, the distance between the price and the indicator will shrink owing to the in-built acceleration factor, thus making for a tighter stop-loss definition as the price continues to move in a favorable direction.

This narrowing of the distance between the SAR line of dots and the price chart results from the use of an Acceleration Factor (AF). This can be set by the user. As new highs are reached, the AF is increased until it reaches the Maximum AF. This parameter can also set by the user.

The higher the AF is set, the more sensitive the indicator will be to price changes. If the AF is set too high, the indicator will fluctuate above and below the price too often, making interpretation difficult. The Maximum AF controls the adjustment of the SAR as the price moves. The lower the maximum step is set, the further the trailing stop will be from the price and the later the stop and reverse will be triggered. J Welles Wilder established .02 as the most effective AF start level and .20 has been determined to be the best setting for the Maximum AF.

For more information see Wilder's book New Concepts in Technical Trading Systems (1978).

Note - The Parabolic SAR indicator is designed to be used in strongly trending markets. The indicator is unreliable during sideways, non-trending periods.

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