What's the Parabolic SAR ?
The Parabolic SAR was also developed by Eng. Welles Wilder (he's also responsible for the RSI and ATR indicators). SAR stands for 'stop and reverse'. Once activated, the Parabolic SAR appears as dots which are positioned either above or below the price chart. When the price is increasing, the dots appear below, and when it's decreasing, they are on top. The image below demonstrates what the Parabolic SAR looks like on a chart. This indicator is used by traders to determine the future short-term movement of an asset. It enables a trader to determine when a stop-order should be placed.
Wilder himself recommended that the Parabolic SAR be used during strong trends, and that it also be used in conjunction with the ADX (it's used for determining the trend strength). Another indicator that can also augment the SAR is the ATR. This one measures the volatility of an asset. Read about the ATR here.
The Parabolic SAR gives more accurate signals during periods of high volatility, as opposed to when it's low (volatility).
The image above clearly shows two periods of low and high volatility on the Parabolic SAR, confirmed by the ATR (Average True Range).
Another indicator that traders utilise in tandem with the SAR is the Simple Moving (SMA). You can read more about the SMA by clicking here.
The use of these two tools together is very popular amongst experienced traders. They do this to confirm the signals provided.
Traders look for two scenarios, namely;
Take a look at the image below.
The yellow line you see is the SMA, and the green & red vertical lines are what we'll refer to as the price.
The white circle labelled "1" shows the price starting above the SMA, and the dots showing a downward movement. This is indicative of scenario #1, the likelihood of a bearish trend.
Conversely, scenario #2 is shown in circle "2". The price is below the price, and the dots are below, showing an upward movement.
So, you can remember this for a bearish trend:
Above - Down - Down
For a bullish trend, you can remember this:
Below - Up - Up
RISK WARNING: YOUR CAPITAL MIGHT BE AT RISK