An indicator used amongst technical traders is the Parabolic SAR (stop and reverse) which determines the momentum of an asset and its direction and the point when there is a strong chance of the momentum switching its direction. Shown as a series of dots put below or above an assets price, the creator of this is J Welles Wilder who has also created other key indicators such as ADX and RSI indicators. The key to the Parabolic SAR indicator is to use it in markets that are trending and can calculate the stop level before the market opens. Traders find this very useful along with the fact that they can determine entry and exit points, however, it is not always the simplest indicator to plot. To take a long position, the stop level must be below the current price level with the stop moving up until the price falls to the stop level. The opposite happens when taking a short position as a trader will set his/her stop above the current price resulting in the stop moving down every day until when the price rises to the stop level.
When constructing a Parabolic SAR, it needs to be calculated separately for every trend in the price. Consequently, the SAR will converge upwards towards the price after starting below it when in an upward trend. When in a downward trend the price converges downwards when the SAR is above the price. It must be re-iterated that the Parabolic SAR be calculated the before the market opens, using data available from the previous day. The formula used is:
SARn+1 = SARn + α ( EP – SARn )
SARn = Todays value, SARn = tomorrows value, EP = extreme point, a = acceleration point.
From this formula, it is important to define some of the terms to fully understand what is being calculated. EP or extreme point represents the highest price point reached during the upward trend and a record of this must be kept during each and every trend.