The Parabolic SAR is another indicator devised by J. Welles Wilder, who also created the RSI and DMI indictors. The Parabolic SAR - or 'Stop and Reversal' as it is otherwise known, is generally used for setting stops and following a trend in the market.
Wilder himeself recommended establishing that a trend was in position first by use of other indicators such as the ADX indicator and then using the Parabolic SAR to trade in the direction of the trend. If the trend was up, then buy when the indicator moved below the price. If the trend was down, then sell when the indicator moved above the price.
The SAR direction is always the same during a trend and the trend stays in place while the SAR points stay above or below the price. When the price penetrates the SAR then a signal is given to exit the current trade and possibly look for a position to take up a new trade in the opposite direction.
The dotted line produced on a chart by the Parabolic SAR can be used for setting a trailing stop on a trade. At the beginning of a move there is always a greater distance between the price and the SAR giving much needed leeway, however this will narrow as the trend continues therefore giving tighter stops as the price moves in a favourable direction.
The calculation for the Parabolic SAR is quite complex and most charting software will calculate it for you. The calculation uses both time and prices, taking the initial acceleration factor (typically 0.02), the addition factor (typically 0.02)and the acceleration factor limit (typically 0.2).