Supertrend Indicator - Formula, Working & Step-by-Step Guide to Use It

Active traders often rely on technical indicators to guide their market decisions, with the Supertrend Indicator being one of the most popular tools for identifying trends. This trend-following indicator helps traders spot entry and exit points by offering clear signals based on price movements. However, understanding how it works and interpreting its signals correctly is key to using it effectively.

In this article we will walk you through the Supertrend Indicator, specifically how it works, how to trade with it, its downsides, and everything else you’ll need to make it part of your trading strategy.

Why Is the Supertrend Indicator Important?

It is a powerful tool for identifying whether a financial instrument is in an uptrend or a downtrend. Supertrend Indicator analyzes the price action in specified time frames to give traders a snapshot of the market trend. 

This indicator works by mapping multiple timeframes into one comprehensive view. By analyzing data across different timeframes, from the last three hours to three months,  it provides insight into how likely a trend is to continue. 

When two or more time frames show the same trend, the indicator signals that the trend is strong and likely to continue. This allows traders to make informed and timely decisions, whether they need an entry or exit strategy. 

Understanding the Formula Behind the Supertrend Indicator

Supertrend Indicator formula uses price data and volatility to determine the prevailing market trend. The formula is structured as follows:

Formula Breakdown:

Supertrend = (High + Low)/2 + (Multiplier × ATR)

1. Midpoint Calculation

The first component of Supertrend Indicator formula, (High + Low)/2, calculates the midpoint between the highest and lowest prices within a specified period. This midpoint serves as a reference point for determining the trend's baseline over the selected time frame.

2. ATR (Average True Range)

ATR measures market volatility, calculated as the average of the true range over a defined period (typically 14 periods). The True Range (TR) for each period is defined as the maximum of:

• The difference between the current period's high and low,
• The absolute difference between the current high and the previous period's close,
• The absolute difference between the current low and the previous period's close.

3. Multiplier

The Multiplier in the Supertrend Indicator formula is a constant factor (commonly 2 or 3) that adjusts the width of the bands. It determines how sensitive the Supertrend line is to price fluctuations. A higher multiplier results in a less reactive line, making the trend more stable and less likely to be triggered by minor market movements.

4. Upper and Lower Bands

Upper Band = (High + Low)/2 + (Multiplier × ATR)

Lower Band = (High + Low)/2 - (Multiplier × ATR)

The Upper Band and Lower Band are calculated by adding or subtracting the product of the Multiplier and ATR from the midpoint (High + Low)/2. These bands define the price range within which the trend is considered valid.

How Does the Supertrend Indicator Work?

Here's a detailed breakdown of how the Supertrend Indicator works and how it helps traders identify market trends:

1. Identifying the Trend Direction

Supertrend Indicator constantly evaluates price fluctuations to assess the current trend. If the price moves upward and sustains a bullish trend, the indicator reflects this with a green line below the price. 

Conversely, when the price moves downward, the indicator shifts to a red line above the price, signaling a bearish trend. This simple color change helps traders quickly identify the market’s direction.

2. Adjusting to Market Volatility

The key to the Supertrend's effectiveness lies in how it adjusts to market conditions. As prices fluctuate, the indicator adapts to the volatility, maintaining an accurate reflection of the market’s movement. 

The ATR is crucial here, as it measures the volatility, and the multiplier determines how sensitive the indicator is to those fluctuations. A higher multiplier makes the line smoother, and a smaller one makes it more responsive to price changes.

3. Generating Buy or Sell Signals

Once the Supertrend line is plotted, it actively tracks price movements. When the price crosses the Supertrend line, it signals potential buy or sell opportunities:

• Buy Signal: When the price crosses above the Supertrend line and the line turns green, it suggests the beginning of a bullish trend, indicating a good time to buy.
• Sell Signal: If the price drops below the Supertrend line and the line turns red, it signals a bearish trend, which may be the right time to sell.

A Step-by-Step Guide to Using the Supertrend Indicator

To use the Supertrend Indicator effectively, follow these detailed steps:

1. Select Your Stock or Index

Start by selecting the specific stock or index you wish to analyze. Open the chart for this asset on your trading platform. Choose a time frame that aligns with your trading strategy. For instance, you can select a 1-hour chart or a daily chart based on how frequently you want to track price movements. Ensure the chart displays sufficient historical data for accurate trend analysis.

2. Apply the Supertrend Indicator

Once the chart is open, add the Supertrend Indicator to it. Most trading platforms will have an "Indicators" section where you can find it. After selecting the Supertrend, set the period to 10 and the multiplier to 3. These are typical settings for many traders, but feel free to adjust them based on the specific asset you are trading or your preferred trading style. The period refers to how many past candles or bars are used to calculate the indicator, and the multiplier adjusts the sensitivity of the Supertrend.

3. Customize Settings for Your Needs

The default settings, which use a 10-period time frame and a 3-times multiplier, are commonly used. However, it's important to remember that each market and asset behaves differently. You may want to experiment with the time period and multiplier based on the asset’s volatility or your personal trading strategy. Shorter time periods (e.g., 7 or 5) might offer quicker signals but could be more susceptible to noise. A larger multiplier (e.g., 5) would make the indicator less sensitive and help avoid false signals, but it may also delay entry and exit points.

4. Use Stop Loss for Risk Management

Risk management is a key part of any successful trading strategy, and using a stop loss with the Supertrend Indicator is crucial. For a long position (buy), set your stop loss just below the green line, which indicates the uptrend. The green line acts as the support level, so placing a stop loss here helps protect you in case the price reverses. For a short position (sell), place your stop loss just above the red line, signaling a downtrend. This ensures that if the market moves against you, your losses will be limited.

How to Interpret the Supertrend Indicator Correctly

Interpreting the Supertrend Indicator is straightforward. Here's how you can do it:

1. Bullish Trend (Long Position)

When the price is above the Supertrend line, it signals an uptrend, indicating a bullish market. This is when traders typically consider entering long positions, as the price is expected to continue rising. The indicator will turn green during this time, confirming that the market is strong and trending upwards.

2. Bearish Trend (Short Position)

On the other hand, when the price falls below the Supertrend line, the market is considered to be in a downtrend. This signals a potential shorting opportunity, as the price is likely to continue dropping. During a bearish trend, the Supertrend line turns red, alerting traders that the market is weak and may continue to fall.

3. Understanding Color Shifts

The color shift of the Supertrend line plays a key role in interpreting market conditions. When the line turns green, it indicates that the price is above the trend line, suggesting potential gains and confirming an uptrend. When the line turns red, it reflects a bearish market with the price below the line, signaling a possible decline and providing an entry point for short trades.

4. Settings Adjustment

The default setting for the Supertrend Indicator works well, but changing the values affects the sensitivity and frequency of the signals. Lower settings will make the indicator more responsive to price changes, generating more signals, but they might also produce false alarms due to increased market noise. Higher settings will reduce noise and prevent false signals but might delay entry and exit points.

Limitations of the Supertrend Indicator You Should Know

While the Supertrend Indicator is a widely used tool in trading, it comes with several limitations that traders should be aware of to use it effectively:

1. False Signals

One of the major drawbacks of the Supertrend Indicator is its tendency to give false signals, especially in sideways or choppy markets. In such conditions, the price may fluctuate without establishing a clear trend, which can cause traders to be prematurely stopped out of positions. This leads to unnecessary losses and missed opportunities.

2. Market Noise

In shorter time frames, market noise can significantly impact the Supertrend Indicator’s effectiveness. Small, insignificant price fluctuations can cause the Supertrend to generate false signals, leading to erratic trade decisions.

3. Asset-Specific Limitations

Supertrend Indicator’s effectiveness may vary across different asset classes, such as stocks, forex, or commodities. It may not be as reliable in certain markets or for specific assets, which can reduce its utility in diverse trading environments.

4. Lagging Indicator

Being a lagging indicator, the Supertrend reacts to price movements rather than forecasting them. This delay in responding can result in missed entry or exit points, especially for short-term traders who rely on quick decisions. As the Supertrend line follows the price, it may not provide the timely insight needed for market shifts.

5. Parameter Selection

Supertrend Indicator requires careful parameter selection, particularly when choosing the multiplier and ATR period. There is no single "perfect" setting that works universally, meaning traders often need to experiment and adjust these values to fit their trading style. Finding the right combination can be time-consuming and requires experience.

6. Limited Functionality

Supertrend is primarily a trend-following tool and does not help identify overbought or oversold conditions. As such, it does not provide a comprehensive picture of market conditions. Thus making it less useful for traders who also want to assess price extremes or market reversals.

Finding the Best Timeframe for the Supertrend Indicator

To find the best timeframe for using the Supertrend Indicator, consider the following key factors:

1. Trading Style

Different trading strategies work best with different timeframes. Position traders and swing traders often prefer longer timeframes. They typically use 1-hour or 4-hour charts to minimize the impact of short-term volatility and focus on major trends.

2. Timeframe for Entry and Exit Signals

Traders can use the Supertrend Indicator on longer timeframes to identify strong trends and then shift to shorter timeframes, like 15 minutes, to capture entry and exit points more precisely.

3. Market Conditions

Volatile markets may benefit from shorter timeframes. However, longer timeframes offer a better overview during stable conditions.

4. Experiment with Settings

Testing different timeframes with the Supertrend Indicator allows you to find the optimal setup that fits your trading approach and goals. Always adjust your settings based on your findings.

Conclusion

In conclusion, the Supertrend Indicator is a powerful tool that can help traders identify trends and make informed decisions. However, understanding its limitations and finding the right settings are crucial for effective use. Whether you're a position trader or someone exploring different timeframes, experimenting with the Supertrend Indicator can lead to more accurate trade entries and exits. 

Remember, the key is to use it alongside other tools for a more balanced strategy. By applying the right approach, you can enhance your trading success and navigate the markets with greater confidence.