The Parabolic SAR (stop-and-reverse) is a technical indicator devised by J.
Welles Wilder, which is discussed in his book 'New Concepts in Technical Trading Systems' published in 1978.
It follows price action and is therefore considered to be a trend following indicator.
The Parabolic SAR, also know as the 'stop and reverse system' is shown on a chart as a series of dots placed either above or below an asset's price level.
The dots are shown below the price level when prices are rising (i.
e.
in an up-trend) and above the price level when prices are falling (i.
e.
in a down-trend).
A parabola (i.
e.
a curve) of dots below the price level is considered to be bullish, while a parabola above the price level is considered to be bearish.
When the price is trending, the dots of the Parabolic SAR will converge upon the price level and signal useful entry and exit points.
It literally stops and reverses where the price trend reverses and breaks either above (if it was previously in a down-trend) or below (if it was previously in an up-trend) the indicator.
One of the beneficial uses of the Parabolic SAR as a stop-loss system is that it doesn't decrease when the price is an up-trend and therefore continuously protects, or locks-in, the profits that have resulted from the advance in price.
Similarly, where there is a down-trend and a short position is taken out, because the Parabolic SAR only ever falls in a down-trend, it protects profits that result from the decline in price.
A limitation of the Parabolic SAR is that it only works well in trending markets.
In non-trending or sideways moving markets it often 'whipsaws', producing many ineffectual stop and reverse signals.
Because of this limitation, Wilder recommended that the technical analyst establish the direction and strength of the trend first before applying this technical tool.
For this, Wilder developed others tools such as the Average Directional Index (ADX).
Because of the attributes of the Parabolic SAR it is often a favourite amongst technical traders and analysts.
Like most technical indicators though, it may be beneficial to add another indicator alongside it to compare.
For instance, a bullish reading of the indicator is given more weight if the price action is trending above a 50 day Moving Average, or similarly, if a bearish signal is given that the price is trending below a 50 day Moving Average.
The Stochastic Oscillator could also be used to identify overbought and oversold territory, therefore increasing the strength of the Parabolic SAR signals if they are aligned.