The “Parabolic Stop and Reverse”, or “SAR”, indicator was developed by J. Welles Wilder to assist in determining the end of a trend and to supplement other trend-following systems. Traders use the indicator to designate optimal exit points. The system gets its name from the parabolic form of “dots” that follow underlying trends.
The SAR is not technically classified as an “oscillator”, but the indicator is often used with oscillators. The parabolic “dots” are easy to interpret. Each point represents a potential reversal in pricing behavior. The dots appear below price indicia on an uptrend and above them on a downtrend. The SAR indicator works best in trending markets, but can give false signals in ranging sideways markets.
Parabolic SAR Formula
The Parabolic SAR indicator is common on Metatrader4 trading software, and the calculation formula sequence can be rather involved. For each step in a trend, the SAR value is calculated one period before. In other words, today’s value is calculated from yesterday’s data. The formula consists of the following steps:
- “SAR+1” = “SAR” + A (“EP” – “SAR”) where
- “SAR” and “SAR+1” are today’s and tomorrow’s SAR values;
- “EP”, or Extreme Point, equals the highest price point during an uptrend, or the lowest price point in a downtrend, and is updated if a new “max” or “min” is observed;
- “A” is the acceleration factor. In forex, it is set to start at “0.02”. It is raised by a similar amount every time a new EP record is recorded. As “A” increases, the SAR converges towards the price of the currency. A maximum value is also set, typically “0.20”.
- There are also “boundary” considerations that modify the SAR in case the iterative calculation produces a value outside of the general form.
- There are also additional rules that apply when a trend suddenly switches. EP and A values are reset, and the process starts all over again.
Wilder also suggested that the Parabolic SAR and the ADX indicators work well in tandem. Software programs perform the necessary computational work and produce a Parabolic SAR indicator as displayed in the upper portion of the following chart with the ADX indicator appearing on the bottom portion:
The next article in this series on the Parabolic SAR indicator will discuss how this trend indicator is used in forex trading and how to read the various graphical signals that are generated.
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