The parabolic indicator, also known as parabolic SAR, is used to find trends in the prices of a market or security. It calculates the Parabolic SAR value based on the most extreme point reached in the current trend and how many times a new extreme point is reached. An analyst plots the movements of the SAR along with the price of the stock or market being tracked to assess the best time to buy or sell shares. Limitations include the whipsaw effect and the need to establish a trend before making decisions based on the SAR.
The parabolic indicator is a technique used to try to find trends in the prices of an entire market or a particular security. It is sometimes known as a parabolic SAR, which means stop and reverse. It works on the principle that the longer a trend continues, the more likely it is to come to an end.
J. Welles Wilder Jr. is usually credited as the creator of the parabolic indicator. Perhaps surprisingly, he was a mechanical engineer rather than an economist. This means that some of his theories are based more on rational patterns than on human behavior.
The theory behind the parabolic indicator is that a trend, that is, a continuous pattern of movement in one direction, has an underlying cause. While some price movements can be self-perpetuating, they will eventually go away unless the underlying cause continues to take effect. If this cause is a single event, as it is in many cases, the effect will eventually wear off.
Using the technique involves calculating a value known as the Parabolic SAR in line with the price tracking under study. This means that if the analyst uses the daily prices of a security, he will also calculate the SAR each day. Calculating the SAR involves a formula that takes into account the most extreme point reached in the current trend, plus how many times a new extreme point is reached. The extreme point is a new high price if the price is trending up, and a low price if the price is trending down. The SAR formula means that today’s market data is used to calculate the SAR for tomorrow.
An analyst using the parabolic indicator will plot the movements of the SAR along with the price of the stock or market being tracked. The theory is that when a stock is going up, the SAR will be below the market price; When the stock is falling, the SAR will be above the market price. The theory also says that the closer the SAR gets to the price, the more likely the trend is to reverse in the near future. An analyst who believes the theory will use this information to assess the best time to buy or sell shares.
An established limitation of the Parabolic indicator is that trends take time to establish. During this period, prices can move in a less predictable manner, known as the whipsaw effect. Wilder recommended that people who follow his theory use other assessment tools to make sure a trend has been established and momentum built before making decisions based on the SAR.
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