Supertrend Indicator: What It Is and How It Works

What Is the Supertrend Indicator?

Developed by Olivier Seban in 2009, this indicator has quickly become a staple in many trading arsenals due to its simplicity and effectiveness. The supertrend indicator is a trend-following overlay that appears directly on price charts, providing clear buy and sell signals based on the underlying asset's price action and volatility. Unlike more complex indicators that can leave investors scratching their heads, the supertrend boils down market movements into a straightforward visual representation: a single line that changes color to indicate potential trend shifts.

Combining elements of moving averages and volatility to generate its signals, the supertrend indicator calculates an average true range (ATR) to measure volatility. Then, it uses this information to plot a line above or below the price action. When the line is green and below the price, it suggests an uptrend; a red line above the price indicates a potential downtrend. This color-coded system allows traders to quickly assess market conditions and make informed decisions.

Below, we'll explore how to apply the supertrend indicator across different time frames and asset classes, from stocks and forex to cryptocurrencies. We'll also examine its strengths and limitations and discuss how it can be integrated with other technical analysis tools to create more robust results. Whether you want to confirm trends, identify potential reversals, or manage risk more effectively, the supertrend indicator can be a valuable addition to your trading tool kit.

Understanding the Supertrend Indicator

The supertrend indicator plots a line on a price chart, which acts as a dynamic level of support or resistance and helps investors make informed decisions about entry and exit points. The line is computed by adjusting the asset’s closing price with a value derived from multiplying the ATR, a measure of market volatility, and a specific multiplier.

When prices are above this line, the market is considered to be trending up, signaling a buying prospect. Conversely, when prices are below the line, the market is trending downward, indicating a sell opportunity.

Here's an example. The image below illustrates the supertrend indicator on the daily candlestick chart of the Invesco QQQ Trust Series 1 (QQQ).

How To Use the Supertrend Indicator

The supertrend indicator isn't just for pinpointing entry and exit points. It can also be used to set up stop losses. For example, if you are in a long position, you can place a stop-loss order at or below the supertrend line. Similarly, if you are in a short position, you might set a stop-loss order at or above the line.

Moreover, the difference between the supertrend line and the asset price can help determine the size of the trading position. The indicator can be applied to more than just individual stocks, currencies, or commodities. It can also identify price trends across entire sectors and asset classes. In other words, traders and investors can use the indicator for asset allocation.

The supertrend indicator is known for its simplicity and works best when prices are going in a clear direction, upward or downward. Like other technical analysis tools, it's more effective when used with indicators.

Components of the Supertrend Indicator

The supertrend indicator is built from two inputs: ATR and a multiplier. ATR shows investors the average range prices swing over a specific period, and the multiplier is what the ATR is simply multiplied by to create distinct price bands above or below the price.

The standard default values of trading platforms for the supertrend indicator are an ATR of between seven and 13 trading sessions and a multiplier of three.

Most investors should be fine with the default option. However, you can adjust the settings, which make the indicator more or less sensitive to the price action.

A shorter ATR time frame and smaller multiplier make the indicator more reactive, creating more signals. This should be more appealing to day traders. Conversely, a longer ATR time frame and larger multiplier do the opposite, making it more suitable for longer-term traders.

Formulas and Calculating the Supertrend Indicator

Usually, you won’t need to calculate the supertrend indicator, as trading platforms do it automatically. However, knowing how it's calculated is worthwhile so you have a better sense of what it tells you. You'll also know better how to adjust the indicator from the default values to better fit your strategy.

Here are the formulas for determining the ATR and upper and lower bands.

Average True Range

ATR = (Previous ATR x (n - 1) + TR) / n

Where:

• n = Number of periods or bars
• TR = True range using one of the following:
• Today's high minus its low
• The absolute value for today's high minus yesterday's close
• The absolute value for today's low minus yesterday's close

If you don't have the previous day's ATR, you need to calculate it using this formula:

(1/n) ∑_iⁿ (TR_i)

Upper and Lower Bands

Once you have your ATR, you can calculate your upper and lower bands using these formulas:

Upperband = (High + Low) / 2 + (Multiplier x ATR)

Lowerband = (High + Low) / 2 - (Multiplier x ATR)

Where:

• High = The highest price of the asset during a specific time frame
• Low = The lowest price of the asset during a specific time frame
• ATR = The range of market volatility
• Multiplier = A constant value that you use to make the indicator more or less sensitive to price movements. Generally, whole numbers are used, but the multiplier can be more specific depending on your trading strategy.

So, suppose the asset you are analyzing has a price high of $20.23 and a low of $19.04. You choose a multiplier of one (for simplicity), and your ATR is $1.15. You would calculate your upper band as follows:

• ($20.23 + $19.04) / 2 + (1 x $1.15)
• ($39.27) / 2 + ($1.15)
• $19.63 + $1.15 = $20.79

Your lower band would be:

• ($20.23 + $19.04) / 2 - (1 x $1.15)
• ($39.27) / 2 - ($1.15)
• $19.63 - $1.15 = $18.48

The upper and lower bands are displayed on the chart and change daily as trading continues.

Interpreting the Supertrend Indicator

The supertrend indicator is straightforward to interpret. Once it creates a line on a price chart, the trend is bullish if the price is above the line, and traders should consider entering long positions. If it's below the line, the signal is bearish, and it could be a good time to go short.

The indicator turns green in an uptrend or when the price is above the line. Conversely, the indicator turns red for a downtrend when the price is below the supertrend line. In other words, green represents the upside, and red represents the downside.

Why Is the Supertrend Indicator Important?

Traders consider the supertrend indicator worthwhile using for the following reasons:

• Simplicity: The indicator is straightforward to use and interpret, making it accessible for all experience levels.
• Adaptability: The indicator can provide dynamic support and resistance levels, adjusting based on market conditions.
• Trend identification: It identifies the general direction of a market trend. This can help you make more informed decisions on entry and exit points.
• Asset volatility: Including the ATR in the formula allows the indicator to adjust for volatility, making it versatile for different conditions and assets.
• Risk management: By providing clear signals for trend direction, the indicator can help you know where to set stop-loss levels, reducing potential losses.
• Multiple time frame analysis: You can apply it to various time frames, from intraday to long-term charts.
• Confirmation tool: The indicator is more reliable when used with other technical indicators like moving averages or the relative strength index (RSI) for confirmation.
• Versatility: It can be used across asset classes, including stocks, currencies, and commodities.
  

Limits of the Supertrend Indicator

Investors should be aware of these supertrend indicator constraints:

• Lagging nature: The supertrend indicator is a lagging indicator, meaning it tends to react to price movements rather than predict them. This could delay your entry or exit if you rely on it.
• False signals: The indicator is prone to generate false signals, particularly in sideways or “choppy” markets when the price moves don’t have a clear trend. This could lead to whipsaws when traders are stopped out of positions prematurely.
• Sensitivity settings: Investors need to choose the correct multiplier and ATR period. This can be challenging. The incorrect setting could make the indicator too sensitive or slow, making it less useful.
• It’s not a stand-alone tool: While the indicator is clear about trend directions, it is not a stand-alone tool. It's most effective when used with other technical indicators or forms of analysis.
• Limited functionality: The indicator is primarily a trend-following tool and may be ineffective for rangebound strategies or identifying overbought or oversold circumstances.
• Market noise: This could have an outsized influence on the indicator in shorter time frames, leading to less reliable signals. Technical analysts generally consider the indicator better at reading longer time frames like daily or weekly charts.
• No information on magnitude: The indicator provides no information on the strength or magnitude of trends, only their direction. Traders often use other tools like the RSI to gauge the strength of a trend.
• Asset-specific limitations: The indicator’s effectiveness can vary across asset classes and market conditions.

Combining the Supertrend Indicator With Other Strategies

The supertrend indicator shouldn’t be the only tool for planning your trades. It works best when integrated with other forms of technical analysis.

Doing so can help make up for some of its biggest weaknesses, such as its lag, lack of effectiveness when there's no clear price trend, and inability to determine the trend strength. Each technical indicator looks at a specific thing and comes with its own strengths and weaknesses. Therefore, in theory, leaning on more of them allows you to cover more angles and strengthen your ability to make the right call.

Experienced traders seldom submit an order based on one indicator. They will wait for others to confirm the pattern before proceeding. They also use tools that complement each other. For example, the supertrend indicator can identify a market trend, and the RSI, stochastic oscillator, or average directional index can be employed to predict the strength of that trend.

The supertrend indicator works well with other popular indicators, including those summarized below:

The Bottom Line

The supertrend indicator is a widely used and versatile tool designed primarily to identify a market or asset's price direction. It provides clear buy or sell signals based on the direction of trends, clues about where to place stop losses, and adjusts itself to market volatility. The indicator plots a line on the price chart, serving as a dynamic level of support or resistance, which flips its position relative to the price when a trend changes.

However, like all indicators, it isn't foolproof, and its effectiveness can waver based on the asset being traded, market conditions, and your financial product strategy. That means it shouldn't be the only tool used to make investment decisions and works best when combined with other forms of technical analysis.