Technical analysis is a complex and exciting arm of the investment world. Instead of looking at the fundamental strength of a company, many traders base their decisions solely on the appearance of a price chart. The methods widely vary, and the Parabolic Stop and Reverse (PSAR) technique is one system that analyzes chart activity to predict price moves. PSAR analysis is appropriate for any auction-based market that offers data in the form of price charts.
The PSAR charting indicator was developed by one of the most influential analysts in the finance world: Welles Wilder. His research has led to many important chart study methods. In 1978, he unveiled the PSAR concept in a book, "New Concepts in Technical Trading Systems." As with any technical indicator, the investing community acquires an understanding of its value over time. Most indicators evolve into trading systems beyond their initial design as traders better grasp the behavior and implications of their formulas.
As with all technical indicators, the PSAR study is only appropriate for certain market conditions. Market activity can be categorized according to directional conviction. At any given time, a market is either trending with a clear move up or down, or is "rangebound" and moving back and forth within a price range. PSAR analysis depends on trending activity to have any value. Without a clear trend underway, the PSAR study can present inaccurate signals that could cost a trader money.
The PSAR formula takes into account the highest and lowest prices of a preceding set period of time and an "acceleration factor" that analyzes the degree of change between them. The PSAR plots a point outside the price range as an indication of the furthest distance price could reverse and still be considered in a trend. In this way, the PSAR offers a visual display of the inherent volatility that could present within a strong trend. When a PSAR plot point is reached, the indicator immediately starts analyzing for a trend in the opposite direction.
A key purpose of the PSAR indicator is to inform traders when they should exit an existing trade before a reversal reduces profits. Trades initiated by other methods can employ the PSAR as their exit strategy. Since the PSAR relies on a trending environment, other trading systems based on trend analysis are best combined with the PSAR. Another Wilder tool, the ADX chart study, analyzes the degree of trend confidence in a market and is an appropriate tool to confirm PSAR analysis.
Some traders seek to have exposure to a market environment all the time. The PSAR is designed to signal when these traders should not just exist their trades, but immediately take the opposite position. As soon as the PSAR switches to plotting points on the opposite side of the price action, the trader reverses her position. This continues for as long as the market demonstrates trending activity. On a smaller time frame, these changes could occur frequently and keep a trader riding the waves of a market.
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