The Parabolic SAR is an indicator that, like Bollinger Bands is plotted on price, the general idea of which is to buy into up trends when the indicator is below price, and sell into down trends when the indicator is above price. Once traders are in positions the indicator also assists in managing the position by providing guidance as to how one should trail their stop.
While this is an indicator that works very well in trending markets, as you can see from the below chart simply following the basic be long when the indicator is below price and be short when the indicator is above price will lead to many whipsaws in range bound markets.
To combat this problem the developer of the indicator J. Welles Wilder (who also developed the RSI and ADX) recommended establishing the strength and direction of the trend first through the use of things such as the ADX, and then using the Parabolic SAR to trade that trend. As mentioned above although the Parabolic SAR is used for both entering and managing positions, it is used far more to set stops once in a position.
As with the other indicators we have covered in past lessons it is recommended to use this indicator in conjunction with other methods of analysis for confirmation not only on trade entry but also on trade exit.