Parabolic SAR, or parabolic stop and reverse, is a technical analysis tool developed by the prolific J Welles Wilder. It is a common tool on many trading platforms and can be used for stocks, forex, options and futures.
It shows itself as a series of dots that are under the candlesticks in an upward trend and above them in a downward trend. Each dot represents a potential reverse in pricing behaviour.
Parabolic SAR is used to tell when a trend has changed direction as the dots will move from above the candlesticks to below or vice versa.
When the dots move below the candlesticks this signifies the start of an uptrend and is a cue to buy; dots switching to above the candlesticks indicate the start of a downtrend and this is therefore a cue to sell or short sell.
One of the uses of the parabolic SAR is the positioning of stop loss orders. Rather than putting a stop loss order just below the price that a long position was taken out at or just above a short position’s original price, a trailing stop can be based on the parabolic SAR line.
Thus the point when the stop loss order comes into play will increase with a rising price on a long position and decrease with a falling price on a short position.
This versatility means that profits can be locked in.
Parabolic SAR does have its limitations, though. It works best in markets that have clear trends. In a sideways market the dots will tend to bounce up and down in an unhelpful way, giving constant trade signals and false indications.
While the parabolic SAR is good at indicating the change of direction of a trend, it does not show how strong that trend is. For this reason it is better to combine it with another indicator.
Welles Wilder recommended using it together with the average directional index or ADX. This index shows the strength of a trend, while its two accompanying lines show the direction. The DI+ line is the positive direction indicator and the DI- line shows negative movement.
So once the dots have moved below the candlesticks you would also look for an ADX reading of more than 25 (this level indicates a trend worth investigating) and for the DI+ line to have crossed above the DI- line before you invest.