The indicator is used to set trailing price stops and is sometimes referred to as the "SAR" (stop-and-reversal), 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 moves below the price. If the trend is down, sell when the indicator moves above the price.
Lets look at the calculation of the indicator ( and don't worry if you find it confusing, its plotted visually on most major chart services) and then some tips on how to apply the indicator in your currency trading system.,
The closing price (parabolic) is calculated for each bar using the following formula:
SAR (i) = ACCELERATION * (HIGH (i - 1) - SAR (i - 1)) + SAR (i - 1)
SAR (i) = ACCELERATION * (LOW (i - 1) - SAR (i - 1)) - SAR (i - 1)
The Following apply in relation to the above:
SAR: (i - 1) — parabolic value on the preceding bar,
Acceleration: – acceleration factor; for the first bar it is usually 0.20, and is calculated as follows:
AF = 0.20 + n x 0.02, where n – the number of new tops (bottoms),
HIGH (i - 1) — high of the previous period,
LOW (i - 1) — low of the previous period.
How to Use the Indicator
The formula is quite complex but don't worry, you don't need to know how an internal combustion engine works to drive a car and interpretation of the indicator is relatively easy, when seen visually on an FX chart.
The dotted lines below the price establish the trailing stop for any long position and the lines above establish the trailing stop for any short position. At the beginning of the move, the Parabolic SAR will provide be wider between the price and the trailing stop but as the trend develops, the distance between the price and the indicator will start to decrease, making the stop-loss tighter as.
If you are long (i.e, the price is above the SAR), the SAR will move up each day, regardless of the direction the price is moving. The amount the SAR moves up will depend on the how much the price actually moves in the trading session.
There are two variables involved: the step and the maximum step.
The higher the step is set, the more sensitive the indicator will be to price changes. If the step is set too high, the indicator will fluctuate above and below the price too often which can generate false trading signals. The maximum step 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, Wilder recommended that the step should be set at .02 and the maximum step at .20 but of course traders can use it as they wish.
Points to Keep In Mind
This indicator is effective only in trending currencies and helps to define the direction of the prevailing trend and also, gives you a warning of when to close the trade, when a trend reversal may be at hand.
When the price chart crosses Parabolic SAR it may be a reversal signal or may indicate temporary consolidation, hence, it is considered as a warning to initiate a position in the market.
Parabolic SAR and trend direction are the same and if the parabolic moves higher, then the trend is bullish and it's a mirror image in a bear market.
If there is a significant divergence between the price chart and the parabolic, this is a warning that convergence may happen.
When the indicator has completely formed and the Parabolic SAR moves parallel to the price chart, most of the signals will be accurate but after this, they tend to contract, the number of false trading signals generated increases.
If you are interested in a currency trading indicator which has stood the test of time ( Like all Welles Wilder Indicators have) check out the book “ New Concepts in Technical Trading” and the Parabolic Time Price System in more detail and see how it can enhance the profitability of your currency trading strategy.