This indicator was developed by J. Welles Wilder.
The terms Stop and Reverse (SAR) and Parabolic come from the parabolic shape of the curve seen at trend reversals. Some traders use the Parabolic SAR in trending markets, to continuously adjust their stop-loss orders, thereby “locking in” profits generated in the trend.
A typical strategy is to buy (in uptrend) when the Parabolic SAR indicator moves below the current price, and sell (in downtrends) when the indicator moves above the current price.
The indicator is, however, not of much use when the market is in a fluctuating trading range with no clear trend pattern, as it may give confusing signals.
The formula is relatively complex, but is based on a few basic concepts:
The first assumption is that a position is entered when a price penetrates SAR.
Extreme Point: The Highest price in the period during an upwards trend (the most favorable price achieved so far if you are “long” in the market) or the Lowest price in the period during a downwards trend (a “short” position).
Acceleration Factor (or Incremental Step factor) should be defined. The default is 2%, meaning the Acceleration Factor starts at starts at 2% for a new trade and each time-point when a new extreme point is reached (in the same trend direction), it increases by 2%, up to a defined maximum (Maximum Step).
The Maximum Step is set to a default of 20% (maximum step 0.2), after which point the factor ceases to accelerate. The maximum is typically 10 trading days with new extremes in one direction. But this factor can be adjusted as well.
The Acceleration Factor (AF) means that the longer the market stays in the same trend, the more steeply the SAR indicator rise, eventually taking the shape of a parabola until at some point price and the SAR dots meet. This secures, that when using SAR as a trading system, the stop (if you are long) will move up every day, regardless of the direction the price is moving (the TIME function), and the stop is also a function of PRICE because the distance by which the stop moves up is relative to the favorable distance the price has moved. With SAR, Welles Wilder arguably created a concept allowing just enough time in the market to benefit from a market move, but also ensuring that if the move does not materialize, an “intelligent” stop and/or reversal of the position is automatically identified. The SAR point of the day is the level where stops and reversals should/could be placed.