The parabolic stop-and-reverse, or parabolic SAR, is an intriguing technical tool which is quite unlike the usual indicators you come across. It was designed by Welles Wilder, a technical trader who also designed the better known Relative Strength Indicator (RSI) that you are probably familiar with. The purpose of the Parabolic SAR is to give you trailing stops on your price chart.
Now the way that the Parabolic SAR is calculated is complex, so the calculations are not included here – if you are interested, you can find out about them in Wilder's book, 'New Concepts in Technical Trading Systems', which was first published in 1978 but is still considered an authority in trading literature. How it is calculated does not impact on its use. In summary, the indicator increases by an amount based on the Average True Range (ATR) as the price hits new highs, so it accelerates when higher highs are made, and decelerates with lower highs.
What this means is that the indicator is just below the price line in an uptrend, farther away when the trend is strong, but getting closer to it when the uptrend starts to wane. This is just what you want for a trailing stop, as the lessening of the strength of the uptrend signals that there may be some hesitancy or reversal approaching, and this is when the Parabolic SAR is closest to the price, ready to provide a stop loss position.
If you look at a chart with the Parabolic SAR plotted on it, you will see that unusually it jumps when there is a change in trend. In an uptrend the price is over the indicator, as mentioned above, but in a downtrend the Parabolic SAR moves to above the price, still fulfilling its designed function of providing a trailing stop position, but this time for an in trend (short) trade. Wilder himself stated that the location of the indicator told you what type of trade you should be in – if the price was above the SAR, then you should be long, and if below you should be short.
Another way to look at the SAR is as a moving support or resistance line, which if breeched signals that you should exit the position. Not only does the SAR give you a trailing stop, but the distance from the price is self adjusting, the combination of which is possibly unique amongst indicators.
As a strategy, you can make sure that you are on the right side of the trade by the question of whether the price is above or below the indicator, but this is just for confirmation. The best use of this indicator is in a trending market, when your moving stop loss order should exit you from your trade if the price drops to the last day's SAR level. As this may be difficult to automate, you should inspect the chart each night to see whether the SAR has been triggered.