Supertrend Indicator

The supertrend indicator is a popular technical analysis tool used in finance to identify the direction of a trend and potential entry and exit points in a financial instrument's price movement. Traders and investors widely use it to make informed decisions about when to buy or sell assets like stocks, currencies, commodities, and cryptocurrencies.

It provides potential entry and exit signals for traders. When the price crosses above the supertrend upper line, it can be seen as a potential buy signal, indicating a possible uptrend continuation. Conversely, when the price crosses below the supertrend lower line, it might be interpreted as a sell signal, suggesting a potential downtrend continuation.

• The supertrend indicator helps identify prevailing trends (uptrend or downtrend) in a financial instrument's price movement.
• It provides dynamic support and resistance levels through its Supertrend Upper and Lower Lines.
• The indicator generates potential entry signals when the price crosses the Supertrend lines, indicating buy or sell opportunities.
• The Supertrend Indicator adapts to market volatility using the Average True Range (ATR), making it more sensitive to changing price movements.

The supertrend indicator is a financial technical analysis tool to help traders identify trends and potential trading opportunities within a price chart. It's designed to provide a dynamic representation of market conditions and aid decision-making. The indicator is derived from a combination of the Average True Range (ATR), which gauges market volatility, and a user-defined multiplier factor.

It was developed as a way to enhance traditional trend-following methods in trading. It was created to adapt to changing market conditions and provide more precise signals for entry and exit. The exact origin and developer of the supertrend indicator might vary as it has evolved through contributions from different traders and analysts.

The Supertrend Indicator calculates two lines on a price chart:

1. Supertrend (Upper) Line: This line is determined by adding the product of the ATR and the user-defined multiplier to the highest high price over a specified period.
2. Supertrend (Lower) Line: This line is calculated by subtracting the product of the ATR and the multiplier from the lowest low price over a specified period.

These lines effectively act as dynamic support and resistance levels, adapting to changes in volatility. Here's how traders interpret the indicator:

• When the price is above the supertrend upper line, it suggests an ongoing uptrend, indicating that the asset's price will continue rising.
• The price below the supertrend lower line implies a prevailing downtrend, suggesting that the asset's price will likely continue falling.
• Crossovers between the price and the supertrend lines can indicate potential entry or exit points. For instance, if the price crosses above the supertrend upper line, it might signal a potential buy opportunity, while a cross below the supertrend lower line could indicate a possible sell opportunity.

The supertrend indicator has two main parameters that traders can customize to adjust its behavior according to their trading preferences and the market characteristics they are trading. These parameters are:

1. Period Length: The period length determines the number of bars or candles the indicator uses to calculate its values. It affects the sensitivity of the indicator to price movements. Moreover, a shorter period will make the supertrend indicator react more quickly to price changes, while a more extended period will result in a smoother and slower response. Traders must find a balance based on their trading style and timeframe. Standard period lengths might be 7, 14, 20, or 50 periods, among others.
2. Multiplier Factor: The multiplier factor is a user-defined value that influences the distance between the supertrend indicator's lines and the price. It determines how much the indicator's lines adjust based on volatility. A larger multiplier will widen the distance between the lines and the price, making the hand more tolerant of price fluctuations. Conversely, a smaller multiplier will make the lines closer to the price, resulting in a more sensitive indicator. The choice of the multiplier depends on the trader's risk tolerance and the volatility of the asset being traded. Common multiplier values are often between 1 and 3.

The supertrend indicator's formula involves two main components: the Average True Range (ATR) and a multiplier factor. Also, the ATR measures volatility, while the multiplier adjusts the indicator's sensitivity to market movements. Here's the formula for calculating the supertrend indicator:

#1 - Average True Range (ATR):

• Calculate the True Range (TR) for each period:
  • True Range (TR) = Max (where High is the highest price, Low is the lowest price, and Close_prev is the previous closing price)

• Calculate the Average True Range (ATR) over the specified period:
  • ATR = (ATR_prev * (period - 1) + TR_current) / period

#2 - Multiplier Factor: 

• This is a user-defined value, often denoted as "Multiplier."

#3 - Supertrend (Upper) Line:

• Supertrend Upper Line = High + (Multiplier * ATR)

#4 - Supertrend (Lower) Line:

• Supertrend Lower Line = Low - (Multiplier * ATR)

These calculations produce the supertrend indicator's upper and lower lines, which can be plotted on a price chart to visualize trends and potential trading opportunities. The Supertrend indicator adapts to market volatility due to its reliance on the ATR. In periods of higher volatility, the lines move farther away from the price, reflecting the larger potential price swings. Conversely, the lines move closer to the price in periods of lower volatility, indicating smaller potential price movements.

Trading strategy that uses the supertrend indicator:

1. Setup:

• Apply the supertrend indicator to the price chart with chosen period length and multiplier factor.
• Determine trade timeframe (e.g., 15 minutes, 1 hour, daily).

2. Trend Identification:

• Look for the direction of the supertrend indicator's lines (upper and lower).
• When the price is consistently above the supertrend upper line, it suggests an uptrend.
• When the price is consistently below the supertrend lower line, it suggests a downtrend.

3. Entry Points:

• Consider potential buy signals in an uptrend when the price pulls back to touch or slightly crosses below the supertrend upper line, indicating a temporary dip in the trend.
• Look for potential sell signals in a downtrend when the price rallies to touch or slightly crosses above the supertrend lower line, indicating a temporary retracement.

4. Exit Points:

• Set profit targets based on support/resistance levels, Fibonacci levels, or other technical analysis tools.
• Alternatively, consider using the opposite supertrend line as a dynamic trailing stop—for example, trail stop loss along the supertrend lower line in an uptrend as it moves upward.

5. Risk Management:

• Place a stop-loss order just below the supertrend upper line (in a buy trade) or just above the supertrend lower line (in a sell trade) to protect against potential trend reversals.
• Adjust position size based on risk tolerance and the distance between the entry point and stop-loss level.

6. Confirmation:

• Consider using other technical indicators, such as moving averages, relative strength index (RSI), or Moving Average Convergence/Divergence indicator (MACD), to confirm the supertrend signals.
• Pay attention to crucial support and resistance levels that align with the Supertrend signals.

7. Avoid Choppy Markets:

• Avoid trading when the price moves sideways or in a congested range, as the indicator's signals might not be reliable in such conditions.

Here is a step-by-step guide on how to use the indicator:

#1 - Apply the Indicator:

• Open preferred trading platform or charting software.
• Select the financial instrument you want to analyze.
• Apply the supertrend indicator to the price chart.

#2 - Choose Parameters:

• Decide on the period length and multiplier factor for the supertrend indicator.
• These parameters will impact the indicator's responsiveness and sensitivity to price movements.

#3 - Trend Identification:

• Observe the supertrend indicator's lines (upper and lower) about the price.
• When the price is consistently above the supertrend upper line, it suggests an uptrend.

#4 - Entry and Exit Signals:

• Look for potential entry points based on the supertrend indicator:
  • In an uptrend, consider buying when the price pulls back to touch or slightly crosses below the supertrend upper line.
  • In a downtrend, consider selling when the price rallies to touch or slightly crosses above the supertrend lower line.
• Determine exit strategy based on profit targets, risk tolerance, and market conditions.

#5 - Risk Management:

• Set stop-loss orders just below the supertrend upper line (in a buy trade) or just above the supertrend lower line (in a sell trade) to protect against trend reversals.
• Calculate position size based on risk tolerance and the distance between the entry point and stop-loss level.

#6 - Adapt to Market Conditions:

• Use other technical indicators or analysis tools to confirm the supertrend signals.
• Look for patterns, support/resistance levels, and trendlines that align with the supertrend indicator's signals.

#7 - Adapt to Market Conditions:

• Be aware that the supertrend indicator works best in trending markets. Avoid trading in choppy or sideways market conditions, as the indicator's signals might be less reliable.

#8 - Backtesting and Practice:

• Practice using the supertrend indicator on historical data to see how it would have performed.
• Refine strategy based on the outcomes of backtesting.

Here's how to identify buy and sell signals using the supertrend indicator:

#1 - Buy Signals

#1 - Uptrend Confirmation

• Look for a consistent uptrend on the price chart, where the price makes higher highs and lows.
• Ensure that the supertrend upper line also rises, indicating a bullish trend.

#2 - Dip Below Supertrend Upper Line:

• In an uptrend, when the price temporarily pulls back and touches or slightly crosses below the supertrend upper line, it can generate a buy signal.
• This suggests that the price might be experiencing a retracement within the uptrend, presenting a potential buying opportunity.

#3 - Confirmation Indicators:

• Use other technical indicators (e.g., moving averages, RSI) to confirm the buy signal from the supertrend indicator.
• Look for bullish candlestick patterns or chart patterns that align with the buy signal.

#4 - Risk Management:

• Set a stop-loss order below the supertrend upper line or a recent support level.
• Calculate position size based on risk tolerance and the distance between the entry point and stop-loss level.

#2 - Sell Signals

#1 - Downtrend Confirmation:

• Observe a consistent downtrend on the price chart, where the price makes lower highs and lower lows.
• Ensure that the supertrend lower line also declines, indicating a bearish trend.

#2 - Rally Above Supertrend Lower Line:

• When the price rallies and touches or slightly crosses above the supertrend lower line, it can generate a sell signal in a downtrend.
• This suggests that the price might be experiencing a temporary upward movement within the overall downtrend, presenting a potential selling opportunity.

#3 - Confirmation Indicators:

• Use additional technical indicators or analysis tools to confirm the sell signal from the supertrend indicator.
• Look for bearish candlestick patterns or chart patterns that align with the sell signal.

#4 - Risk Management:

• Place a stop-loss order above the supertrend lower line or a recent resistance level.
• Calculate position size based on risk tolerance and the distance between the entry point and stop-loss level.

Let us look at the Euro/ US Dollar chart below to understand the concept of the supertrend indicator. 

Source

In the chart, the green and red lines represent the indicator. The formation of the red line takes place above the price or candlesticks. On the other hand, the green line forms below the candlesticks. Traders can carry out an analysis of how the colors change to determine buy-and-sell opportunities. 

Simply put, when the price is below the red line, it is a sign that the traders may consider entering a short position or exiting their long position. On the other hand, if the price is above the green line, it is a bullish signal. In other words, traders may consider entering a long position or exiting their short position. 

As one can observe, the price was above the green line on September 15, 2022. This suggested a bullish trend was on the horizon. If traders considered the signal and entered a long position, they would have made significant gains from the uptrend. s a

If a trader wishes to gain more information regarding how this indicator works, they can observe the various charts on TradingView that show how one can utilize the indicator to make financial gains in the market.

Let us understand it better.

Example #1

Imagine Jack is a stock trader analyzing shares of Company XYZ. Jack is using the supertrend indicator with a period length of 20 and a multiplier of 2 on a daily chart. Here's what he observes:

• Company XYZ has been in a consistent uptrend over the past few months, and the supertrend upper line has been providing dynamic support for the price.
• On a particular day, the stock price experiences a significant dip, causing it to cross slightly below the supertrend upper line.

Considering the supertrend indicator's buy signal and the overall bullish trend, he decides to enter a long position on Company XYZ. He sets a stop-loss just below the supertrend upper line to manage potential risk.

Example #2

In 2023 The Economic Times sheds light on an exciting market development as a prominently featured stock experiences a notable breakout, signifying potential substantial gains for investors. The stock's decisive technical breakout reflects bullish market sentiment and has invigorated investor enthusiasm. The stock promises to become a multi-bagger, generating anticipation of achieving fresh record highs.

Financial experts emphasize that this breakout represents an opportune moment for investors to enter the market, regarding it as a strong buy recommendation. Despite the encouraging outlook, investors are encouraged to assess their risk tolerance and investment horizon. As the breakout infuses optimism, a cautious approach backed by thorough research and professional guidance remains essential for prudent investment decisions.

Here are the advantages and disadvantages of using this indicator in trading:

Here's a comparison between the supertrend indicator and the parabolic SAR (Stop and Reverse) indicator:

This has been a guide to what is Supertrend Indicator. We explain its formula, how to use it, examples, advantages, & comparison with parabolic SAR. You can learn more about it from the following articles –

• Accumulation/Distribution Indicator
• Leading Indicators
• Momentum Indicator