What Does Parabolic SAR Do and How Does it Work?

The Parabolic SAR is a technical Indicator which was built-up to analyze the different market trends. This indicator is greatly shown on the price chart. This type of indicator is quite alike to the Moving Average Technical Indicator having the only difference of that Parabolic SAR moves with higher acceleration and may change its position in terms of the price.
Mr. Welles Wilder made the Parabolic System who at the same time developed the Relative Strength Index (RSI), which is usually referred to as the Parabolic SAR or the stop and reverse. He planned this indicator to append the other systems which have followed certain trends. It is an outstanding indicator for presenting exit points which shows sell signals when the parabola moves above the price while buy signals are created when the parabola falls below the price.
This type of indicator gives useful advantage to catch up on the prevailing market trend which offers excellent buy and sell signals. Such signals are needed to be confirmed by the price action itself and other complementary indicators. Long positions should be taken if the price submerged below the SAR line; on the other hand, short positions should be taken when the price moves above the SAR line. It is quite often that the indicator serves as an irregular stop line. A parabola below the price is generally chipper while a parabola above the price is generally endurable.
If the price intersects the Parabolic SAR lines, the indicator will turn and its auxiliary values are positioned on the other side of the price. When the indicator makes a turn, it will give a signal of the trend end correction stage or flat, or in short its turn. When such an indicator turn does happen, the maximum or the minimum price for the previous period would serve as the starting point.
The SAR may be calculated independently for each individual price trends. If a price is in an uptrend, the SAR moves below the price and gather together upwards towards it. Corresponding to it, on a downtrend, the SAR is above the price and touch downwards. In every step of the boundaries of the trend, this is calculated ahead of time. Meaning, the value is already constructed using the data that is available today. The parabolic SAR formula that you should use is:
SARn + 1 = SARn + a (EP- SARn)
SARn and SARn + 1 should be taken as today’s and tomorrow’s numeric values. EP is the extreme point. It is a record that is maintained at each trend which shows the highest value that prices have reached during the current uptrend while the lowest value during a downtrend. On every period, if a new maximum or minimum is viewed, the EP will be updated to correspond to that value. The a value on the other hand stands for the acceleration aspect. More often than not, this is set to a value of 0.02 and each time a new EP is documented this factor is increased by 0.02. In other words, each time a new EP is observed, it will definitely increase the acceleration feature.