Parabolic SAR is a trend following indicator that is often used as a trailing stop. Parabolic SAR indicator was introduced in 1978 by J. Welles Wilder, Jr. in his famous book, “New Concepts in Technical Trading Systems.”The term Parabolic is used because when this indicator is applied to the chart it forms strings of dots that look like a parabola, a shape you might remember from high school algebra.
The term SAR on the other hand simply means Stop and Reverse because when reached by price action, this indicator switches direction and reverses to the other direction. So a Parabolic SAR is used to identify entry and exit points based on a trailing stop that reverses when reached by the price action.
Before we talk about how to use Parabolic SAR indicator in trading, we need to understand a few terms that are often used when using Parabolic SAR. High Point (HP)is the high of a candle that has a high higher than the highs of the candles adjacent to it on its left and right. In the same manner, Low Point (LP) is the low of a candle that is lower than the lows of the two adjacent candles on the left and right. Similarly, a Significant Point (SP) is the highest price during a long trade and the lowest price during a short trade.
Another very important term that you need to understand while using Parabolic SAR is the Acceleration Factor (AF). At the beginning of every trade, Parabolic SAR dots move with increasing rate dependent on the AF. AF has the default value of 0.02 and 0.2. What this means is that AF starts from 0.02 and ends up at 0.2. At the formation of each HP or LP, AF is incremented by 0.02. AF stops incrementing when it reaches 0.2 level. These HP, LP, SP and AF are used in calculating Parabolic SAR values.
The default settings are 0.02 increment and the max level of 0.2 for Parabolic SAR. If you decrease the increment to a lesser level like 0.01, there will be lesser reversals for Parabolic SAR. On the other hand, if you increase the increment settings to say 0.03, there will be more reversals and whipsaw. Calculating the value of Parabolic SAR is done automatically by the charting software. You just need to keep the above basic facts when trading with Parabolic SAR. Just keep this fact in mind that the first Parabolic SAR value is calculated from the SP from the previous trade.