Parabolic SAR is a very useful technical indicator during trending periods. However, it shouldn’t be used if there is no trending period. Trend periods exist approximately 30% of the time.
In trending markets it provides useful entry and exit points. The name parabolic comes from its shape which is like a parabola. SAR lets our investor follow the dots in an upward or downward trend until SAR is reached and then the trend reverses.
SAR’s stop loss is calculated for each day via the previous days data. The first entry point can be seen when the latest high price has been broken – now the SAR is placed at the most recent low price.
Now as the price starts to rise, the dots on the chart rise as well – starting slowly and then going on with increasing speed in the direction of the trend.
Before you consider using SAR, make sure you actually are working with a trending market as otherwise you’re dead. To do that you can either use a trend indicator or stop trading SAR once you have been whipsawed twice in a row.
To get a trade signal you’ll need to wait until price bars and stop levels intersect. You should go long when price meets Parabolic SAR stop level, while short. And vice versa. Note that Parabolic SAR is more popular for setting stops than for establishing direction or trend. First wait for the establishment of a trend and then trade in the direction of a trend with Parabolic SAR. If the trend is up, buy when the indicator goes below the price. If the trend is down, sell when the indicator goes above the price.
You should ignore signals when the price is ranging or basically when you don’t see any major movements. Exit when price activates the SAR stop. Do not go short when moving average is going upwards. Go long when price crosses back above the top and MA is still upwards.
I have been searching, but so far I haven’t been able to find the exact formula on how the Parabolic SAR is constructed. But there are two variables – step and maximum step. The sensitivity of the indicator depends on the step size – the higher the more sensitive. You shouldn’t set it too high as then you won’t get a too good reading. The maximum step controls the adjustment of the SAR within the price movements. The lower the maximum step is set, the further the trailing stop will be from the price. Good values for the steps are – step=.02 and maximum step .20.
You can see an example Parapolic SAR here.
PS: Parabolic SARS can be used in conjunction with the Williams %R indicator as they tend to function similar way on certain trends and signals. Also HLOC or candlesticks charts could be used to study SAR a bit better as these include days high and low prices as well.
PS2: I finally managed to find the calculation for Parabolic SAR.
SAR(i) = SAR(i-1)+ACCELERATION*(EPRICE(i-1)-SAR(i-1))
SAR(i-1) — is the value of the indicator on the previous bar;
ACCELERATION — is the acceleration factor;
EPRICE(i-1) — is the highest (lowest) price for the previous period (EPRICE=HIGH for long positions and EPRICE=LOW for short positions). (thanks to Metaquotes.net)