The parabolic indicator is a technique used to attempt to find trends in the prices of an entire market or a particular security. It is sometimes known as parabolic SAR, standing for 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 some of his theories are based on rational patterns more than human behavior.
The theory behind the parabolic indicator is that a trend — that is, a continued pattern of movement in one direction — has an underlying cause. While some price movements can be self-perpetuating, they will eventually die out unless the underlying cause continues to take effect. If this cause is a one-time event, as happens in many cases, the effect will eventually fade away.
Using the technique involves calculating a value known as the parabolic SAR in line with tracking the price under study. This means that if the analyst uses daily prices for a security, he will also calculate the SAR each day. Calculating the SAR involves a formula that takes account of 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 upwards, and a low price if the price is trending downwards. 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 alongside the price of the stock or market being tracked. The theory is that when a stock is rising, 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 moves to the price, the more likely it is that the trend will reverse in the near future. An analyst who believes the theory will use this information to assess the best time to buy or sell stock.
One established limitation of the parabolic indicator is that trends take time to become established. During this period, prices can move in a less predictable manner, known as a whipsaw effect. Wilder recommended that people following his theory use other assessment tools to make sure a trend has been established and gathered momentum before they make decisions based on the SAR.