Supertrend Indicator: What It Is, How It Works

The Supertrend Indicator is a technical analysis tool that can assist investors in identifying market trends.

Developed by Olivier Seban, the indicator is useful for capturing the direction of an asset’s momentum and is widely employed when looking at stocks, currencies, and commodities. It plots a line on the price chart, which acts as a dynamic level of support or resistance, helping traders and investors make informed decisions about entry and exit points.

The Supertrend Indicator is quite straightforward. Its line is computed by adjusting the asset’s closing price with a value derived from multiplying the average true range (ATR), which is a measure of market volatility, and a specified multiplier.

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

The Supertrend Indicator is notably helpful in markets when prices are going in a clear direction, upward or downward. It is often used with other technical indicators for a more comprehensive trading strategy.

The Supertrend Indicator

The indicator gained prominence when it was integrated into various trading platforms. It is now a staple in markets for stocks, currencies, and commodities for identifying and following market trends.

The image below illustrates the Supertrend Indicator on the daily candlestick chart of the Invesco QQQ Trust Series 1 (QQQ).

Calculating the Supertrend Indicator

The formula for the Supertrend Indicator is designed to capture the direction and volatility of an asset’s price. It can be formulated as follows:

$Supertrend = (High + Low)/2 + (Multiplier)*(ATR)$Supertrend=(High+Low)/2+(Multiplier)∗(ATR)

• High and low: These are the highest and lowest prices of the asset during a specified time frame.
• ATR: This measures market volatility. The ATR is calculated based on the highest and lowest prices, as well as the closing price of the asset over a specified time frame.
• Multiplier: This is a constant value that traders and investors employ to push the indicator to be more or less sensitive to price movements. Generally, whole numbers are used, but the multiplier can be made more specific to fit your trading strategy.

Understanding the Supertrend Indicator

Traders and investors interpret the Supertrend Indicator through its line’s position relative to the asset’s price and its changes in direction. When the asset’s price is above the supertrend line, it generally indicates a bullish trend. Traders and investors often consider this a signal to buy or maintain long positions. Conversely, when the asset’s price is below the supertrend line, it suggests a bearish trend. This is generally interpreted as a signal to sell or maintain short positions.

A change in the supertrend line from below to above the asset price or vice versa might signal a trend reversal. You could take this as an opportunity to enter or exit positions.

The multiplier in the Supertrend Indicator is employed to adjust the indicator’s sensitivity. A higher multiplier makes the indicator less sensitive to price changes and reduces false signals. But it could delay your investment moves. Alternatively, a lower multiplier makes the indicator more sensitive, providing quicker signals but also increasing the risk of false positives.

Since the Supertrend Indicator incorporates ATR, it adjusts in line with the market’s volatility. This makes it adaptable to different market conditions and asset types. Also, the indicator could be applied to various time frames, from intraday to daily or weekly charts.

Using the indicator effectively requires knowing about its strengths and limitations. The indicator is very dynamic, helping to recognize the general direction of a trend. However, a more comprehensive strategy could be developed by combining it with other fundamental and technical analysis indicators.


Why Is the Supertrend Indicator Important?

Traders consider the Supertrend Indicator valuable for several reasons:

• Simplicity: The indicator is straightforward to use and interpret, making it great for traders and investors of all experience levels.
• Dynamic support and resistance: The indicator could provide dynamic support and resistance levels, adjusting itself based on market conditions. This adaptability makes it a versatile tool for various trading strategies.
• Trend identification: The indicator 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 adaptable to 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: The indicator can be applied to various time frames, from intraday to long-term charts, offering flexibility in trading and investment strategies.
• 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: The indicator can be used across different asset classes, including stocks, currencies, and commodities, making it handy for diverse trading and investment portfolios.

Nonetheless, like any technical analysis indicator, the Supertrend Indicator is not foolproof and should only be used in line with a comprehensive trading strategy.

Limitations of the Supertrend Indicator

Investors should be aware of these Supertrend Indicator limitations:

• 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 right multiplier and ATR period. This can be challenging. The incorrect setting could make the indicator too sensitive or too slow, making it less useful.
• It’s not a stand-alone tool: While the indicator is really clear about trend directions, it is not a stand-alone tool when trading. The indicator is most effective when used with other technical indicators or forms of analysis.
• Limited functionality: The indicator is primarily a trend-following tool and may not be as effective for range-bound strategies or identifying overbought or oversold conditions.
• Market noise: In shorter time frames, market noise could influence the indicator, leading to less reliable signals. Investors 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.

Using the Supertrend Indicator

The Supertrend Indicator can be used in trading and investing to help with your decisions and risk management.

First, you can use it to pinpoint your entry and exit points from a market or asset. When the supertrend line moves below price, this is often considered a buy signal, and when it moves above price, this is generally the time to sell.

You can also use it to set your stop-loss levels. 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 supertrend line. This can help you stay disciplined in your trading strategy, sticking to predefined entry and exit points, not ones you decide at the moment.

Of course, given its name, the Supertrend Indicator is great for confirming trends. In addition, you can use the difference between the supertrend line and the asset price to help determine the size of the trading position.

The Supertrend Indicator is also used for asset allocation. Traders and investors can use it to gauge the momentum of assets and allocate their portfolios as a result. Thus, it can provide more robust signals for your trading strategy when used with other technical analysis indicators like moving averages, RSI, or the moving average convergence/divergence (MACD).


An Example of Using the Supertrend Indicator

The Supertrend Indicator is a trend-following indicator. An example of the indicator can be illustrated with the exchange-traded fund (ETF) QQQ on a daily chart.

The buy condition of this strategy occurs when the closing price crosses above the supertrend line. This condition would also close any existing short positions. Conversely, the sell condition is when the close price crosses below the supertrend line. Any existing long positions would be closed.

Suppose you review this basic long and short strategy from Sept. 28, 2022, to Sept. 28, 2023. The strategy assumptions could include the following:

• Initial capital: $1,000,000
• Order size: 100% of equity
• No pyramiding of orders
• Commissions and slippage are ignored
• ATR length: 100
• Multiplier: 2

The results are as follows:

• Net profit of 8.37% ($83,735.36)
• Total closed trades: 5
• Percentage of profitable trades: 40.00%
• Profit factor generated: 1.861
• Maximum drawdown: 8.56%
• Buy and hold return over a similar period: 16.69%

This is an example to show the potential effectiveness of the supertrend. However, it is crucial to note that traders would typically subject the indicator to more extensive backtesting and optimization before looking to it for predictive power.


What Is the Difference Between the Supertrend Indicator and the ATR?

While the Supertrend Indicator often incorporates the ATR in its calculations to adjust for market volatility, the indicator is most frequently used for trend identification and trading signals, while the ATR measures volatility.

How Reliable Is the Supertrend Indicator?

The Supertrend Indicator’s reliability depends on several factors: market conditions, the asset type, and your investment goals. While the Supertrend Indicator might be valuable for identifying trends and managing risk, its reliability is not absolute and should only be used as part of a comprehensive strategy.

Are There Other Indicators Like the Supertrend Indicator?

Other indicators that are similar to the Supertrend Indicator include the MACD, the parabolic stop and reverse, Bollinger Bands, Keltner Channels, and the Ichimoku Cloud.

What Is the Best Time Frame to Use for the Supertrend Indicator?

The best time frame for the Supertrend Indicator depends on your strategy, risk tolerance, and the asset involved. There is no one-size-fits-all approach for the best time frame to use.

What Indicators Work Well with the Supertrend Indicator?

The Supertrend Indicator can be effectively paired with other technical indicators to improve its trading signals’ accuracy and develop a more robust trading strategy. Some indicators that work well with it include moving averages, RSI, Bollinger Bands, MACD, volume indicators, a stochastic oscillator, Fibonacci retracement levels, and the Ichimoku Cloud.


The Bottom Line

The Supertrend Indicator is a versatile tool designed primarily for following trends and is widely used in various financial markets, including stocks, currencies, and commodities. It generates buy and sell signals based on the direction of trends and adjusts itself to market volatility if used with the ATR. 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, its effectiveness can change based on the asset being traded, market conditions, and your investment strategy. Therefore, it should only be part of a well-rounded trading approach.