Introduced by Welles Wilder in his 1978 book, New Concepts in Technical Trading Systems, the Parabolic SAR (PSAR) is an indicator that sets trailing price stops for long or short positions. It is more popular for setting stops than for establishing direction or trend. Wilder’s intent was to create an indicator that capitalized on a trending market and systematized profit taking. The dotted lines below the price determine the trailing stop for a long position and the lines above determine the trailing stop for a short position. At the beginning of a move, the Parabolic SAR creates a greater distance between the price and the trailing stop. However, as the trend develops, the distance between the price and the indicator gets smaller, creating a tighter stop-loss.
Chart courtesy of Prophet Financial Systems
Wilder’s Parabolic SAR can be used as a trading system where you are always in the market – hence stop and reverse (SAR). The position is reversed when the stop is hit. The dots that mark the stop price levels curve like a parabola, and this is where the name was derived. Parabolic SAR is a trend following system.
In an uptrend the dots start out slower but accelerate with the trend. The stop is slow at the outset to allow the trend time to develop. As price accelerates, the SAR moves faster, eventually catching up. The system works very well in trending markets, but gets whipsawed in sideways non-trending markets.
Wilder’s Average Directional Index (ADX) helps to determine whether a market is in a trending state. The best time to use a trending system such as Parabolic SAR, is when the ADX is rising.