The parabolic stop-and-reverse is a technique of technical analysis. It's a school of investing that believes history repeats in the stock exchange. As such, one can predict the trajectory of a security using its stock chart. Welles Wilder, a famous trader, developed the parabolic SAR in the 1970s. Other notable contributions by Wilder to technical charts include the tools Average True Range and Relative Strength Index.
Parabolic SAR, a trend-following indicator, helps traders to gauge the direction of security price movements. In technical charts, the PSAR indicator is represented as a series or dots that are located either above or below candlestick bar. If the dots are below the price line it is considered a bullish signal. This means that the uptrend will continue. If they are higher than the price line, however, it means that the market sellers are in control. The downward trend will continue for some time.
The parabolic indicator of SAR is a lagging indicator that could be used to set a trailing stop loss, or decide on entry or exit points. It's based on asset price trends. Asset prices tend to stay within a parabolic curve if there's a strong market trend.
To determine where the dots will be, the parabolic SAR indicator uses both the most recent extreme price (EP), and an acceleration factor (AF). EP is the highest asset price that it has touched in an uptrend, and the lowest in a downtrend. It is updated each time an EP is reached. The default value for AF is 0.02 and it increases by 0.02 each time an EP is added. A maximum value of 0.20 can be reached.
Here's how PSAR for security in uptrend is calculated:
PSAR = Prior PSAR + Prefer AF (Prior EP-Prior PSAR).
Here's how PSAR for a security in downtrend is calculated:
PSAR = Prior PSAR-Prior AF (Prior PSAR-Prior EP).
This formula can be used to determine the position of a dot at the bottom or top of the rising trendline. You can also connect dots using a line that is based on preference. This series of dots indicates the current price momentum for a security.
When using the PSAR, traders will buy assets if they move below the candlestick bars. This indicates an upward momentum in security prices. Short-sellers can also sell an asset if the series of dots rise above the candlesticks. This is an indication of a downward momentum.
Trade signals will therefore be constant since the trader who uses it will always hold a position in that asset. This might be beneficial if the security swings back and forth, which would give the trader a gain for each trade. If the asset moves only slightly in one direction, the trade signal barrage could result in a series losing trades.
It is a good idea to examine the price chart for the trading session to determine if there is a strong upward trend or downward trend. To determine the direction of the overall trend, another technical indicator like a moving average is recommended. If there is a true trend, traders might use trade signals to follow the overall trend. If there is a downtrend, for example, a trader might use short trade signals to signal that the candles are moving to the top. The trader would then exit the candlesticks when the candles flip to the bottom.
According to Wilder's estimates, the best scenario for the PSAR indicator is assets that show a strong trend. This happens 30% of time. This could mean that PSAR might be susceptible to whipsaws more often than 50% of the time, or when an asset does not trend. Parabolic SAR is best for determining the direction of a security's prices and placing stop-loss order based on that evidence. Parabolic SAR could also give false signals if the asset's value is moving sideways. It is recommended to use it with other technical indicators in order to filter out poor trade signals.