## Introduction

Developed by Welles Wilder, the Parabolic SAR refers to a price and
time based trading system. Wilder called this the "Parabolic Time/Price
System". SAR stands for "stop and reverse", which is the actual
indicator used in the system. SAR trails price as the trend extends over
time. The indicator is below prices when prices are rising and above
prices when prices are falling. In this regard, the indicator stops and
reverses when the price trend reverses and breaks above or below the
indicator.

Wilder introduced the Parabolic Time/Price System in his 1978 book,

*New Concepts in Technical Trading Systems*. This book also includes RSI, Average True Range and the Directional Movement Concept (ADX). Despite being developed before the computer age, Wilder's indicators have stood the test of time and remain extremely popular.## Calculation

Calculation of SAR is complex with if/then variables that make it
difficult to put in a spreadsheet. Feel free to skip to the
interpretation section! These examples will provide a general idea of
how SAR is calculated. Because the formulas for rising and falling SAR
are different, it is easier to divide the calculation into two parts.
The first calculation covers rising SAR and the second covers falling
SAR.

Rising SAR

Prior SAR: The SAR value for the previous period.

Extreme Point (EP): The highest high of the current uptrend.

Acceleration Factor (AF): Starting at .02, AF increases by .02 each

time the extreme point makes a new high. AF can reach a maximum

of .20, no matter how long the uptrend extends.

Current SAR = Prior SAR + Prior AF(Prior EP - Prior SAR)

13-Apr-10 SAR = 48.28 = 48.13 + .14(49.20 - 48.13)

The Acceleration Factor is multiplied by the difference between the

Extreme Point and the prior period's SAR. This is then added to the

prior period's SAR. SAR can never be above the prior period's low or

the current low. Should SAR be below one of these, use the lowest

of the two for SAR.

```
```*Falling SAR**
Prior SAR: The SAR value for the previous period.
Extreme Point (EP): The lowest low of the current downtrend.
Acceleration Factor (AF): Starting at .02, AF increases by .02 each
time the extreme point makes a new low. AF can reach a maximum of .20,
no matter how long the downtrend extends.
Current SAR = Prior SAR - Prior AF(Prior SAR - Prior EP)
9-Feb-10 SAR = 43.56 = 43.84 - .16(43.84 - 42.07)
The Acceleration Factor is multiplied by the difference between the
Prior period's SAR and the Extreme Point. This is then subtracted
from the prior period's SAR. SAR can never be below the prior
period's high or the current high. Should SAR be below one of these,
use the highest of the two for SAR. *

```
```

## Interpretation

SAR follows price and
can be considered a trend following indicator. Once a downtrend
reverses and starts up, SAR follows prices like a trailing stop. The
stop continuously rises as long as the uptrend remains in place. In
other words, SAR never decreases in an uptrend and continuously protects
profits as prices advance. The indicator acts as a guard against the
propensity to lower a stop-loss. Once price stops rising and reverses
below SAR, a downtrend starts and SAR is above the price. SAR follows
prices lower like a trailing stop. The stop continuously falls as long
as the downtrend extends. Because SAR never rises in a downtrend, it
continuously protects profits on short positions.

## Step Increments

The Acceleration
Factor (AF), which is also referred to as the Step, dictates SAR
sensitivity. SharpCharts users can set the Step and the Maximum Step. As
shown in the spreadsheet example, the Step is a multiplier that
influences the rate-of-change in SAR. That is why it is referred to as
the Acceleration Factor. Step gradually increases as the trend extends
until it hits a maximum. SAR sensitivity can be decreased by decreasing
the Step. A lower step moves SAR further from price, which makes a
reversal less likely.

SAR sensitivity can be
increased by increasing the step. A higher step moves SAR closer to the
price action, which makes a reversal more likely. The indicator will
reverse too often if the step is set too high. This will produce whipsaws
and fail to capture the trend. Chart 6 shows IBM with SAR (.01, .20).
The step is .01 and the Maximum Step is .20. Chart 7 shows IBM with a
higher Step (.03). SAR is more sensitive in chart 7 because there are
more reversals. This is because the Step is higher in chart 7 (.03) than
chart 6 (.01).

## Maximum Step

The sensitivity of
the indicator can also be adjusted using the Maximum Step. While the
Maximum Step can influence sensitivity, the Step carries more weight
because it sets the incremental rate-of-increase as the trend develops.
Also note that increasing the Step insures that the Maximum Step will be
hit quicker when a trend develops. Chart 8 shows Best Buy (BBY) with a
Maximum Step (.10), which is lower than the default setting (.20). This
lower Maximum Step decreases the sensitivity of the indicator and
produces fewer reversals. Notice how this setting caught a two month
downtrend and a subsequent two month uptrend. Chart 9 shows BBY with a
higher Maximum Step (.20). This higher reading produced extra reversals
in early February and early April

## Conclusions

The Parabolic SAR
works best with trending securities, which occur roughly 30% of the time
according to Wilder's estimates. This means the indicator will be prone
to whipsaws over 50% of the time or when a security is not trending.
After all, SAR is designed to catch the trend and follow it like a
trailing stop. As with most indicators, the signal quality depends on
the settings and the characteristics of the underlying security. The
right settings combined with decent trends can produce a great trading
system. The wrong settings will result in whipsaws, losses and
frustration. There is no golden rule or one-size-fits-all setting. Each
security should be evaluated based on its own characteristics. Parabolic
SAR should also be used in conjunction with other indicators and
technical analysis techniques. For example, Wilder's Average Directional Index can be used to estimate the strength of the trend before considering signals.

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