Created by the French trader Olivier Seban, the Supertrend is a technical indicator that aims to detect price trends. It is a tool widely used by brokers, for example, LQDFX, analysts. Especially with regard to its usefulness for setting protection "stops".
However, this is not its only quality and we will see below that it is efficient enough to follow the trend while effectively filtering small price movements that represent intermediate corrections but without threatening the underlying trend. We can thus be carried away by a long directive trend, generating the biggest gains.
Calculation
The first step is to calculate the ATR (" Average True Range " which is a measure of volatility) over the entire historical period, then the two bands of the indicator:
Bullish trend = (higher + lower) / 2 + c * ATR (n)
Bearish trend = (higher + lower) / 2 - c * ATR (n)
With:
n: a period of calculation of the ATR, typically 10
c: coefficient making it possible to weigh the volatility measured by the ATR. The standard formula uses a coefficient of 3
On the graphical representation, only the uptrend or the downtrend are displayed, which alternate under the following rule: the trend goes up when the closing price exceeds the previous value of the downtrend. Conversely, when the closing price drops below the uptrend level, it becomes bearish.
Use
The use of Supertrend indicator can be considered in several ways:
Set protective stops: in this case, we will use the indicator as a "trailing stop" which sticks to the trend. Once in a long position, for example, we can set our safety stop on the level of the lower limit of the Supertrend. If the latter is pushed down, it indicates a bearish trend reversal. The indicator reverses and it is preferable to close your long position.
Identify supports and resistances: the indicator allows for example to give a level of support when it is in an uptrend, or resistance when it is in a downtrend. Of course, short-term levels, given the standard period of the indicator which is 10 sessions.
Generate buy/sell signals: if you use the Supertrend for main trading signals, you have to take into account that with this type of indicator, you are always in a position, buying or selling. On the CAC 40 chart above, signals to buy (green arrow) or sell (red arrow) have been materialized.
We see that we did not miss the major trends and that we were in the right direction each time. Notable exception at the end of the chart where the evolution in "trading range" (evolution chopped horizontally and without trend) does not allow to make gains. On the other hand, we also observe that the losses are quite limited since we exit the position relatively quickly in the event of a scenario reversal.
An alternative use will be to return to position when prices come to rely on a band of the Supertrend.
Thus, in an uptrend with the Supertrend which plays a support role, we can switch to a buyer in contact with the indicator, which allows a very tight stop to be set. The graph opposite illustrates the two situations.
In the first case, standard, we enter the purchase on the reversal of the indicator bands. In the second, we take advantage of the support on the support to start buying with a more optimized price. In this last situation, which will be of interest to short-term traders, we have the advantage of being able to place a very tight safety sell (stop), which gives us a very low risk of taking a position.
Conclusion
The Supertrend is particularly good at catching large trends and holding the position throughout without breaking out on small corrections in between. Due to its moderate sensitivity, it will not turn around immediately due to price volatility as other indicators such as the Parabolic SAR for example can. This sensitivity to volatility can also be refined by adjusting its coefficient (which is 3 as standard).
Its fault, like many trend indicators, is that it is irrelevant during the "trading range" phases when the market hesitates by moving without direction. In these cases, it will generate small losses on round trips. On the other hand, they will be largely offset by the advantage of being able to focus on major underlying trends without leaving too early.
Another small flaw to note is the fact that the indicator takes a while to reverse when a trend reverses. It will therefore be difficult to capture market extremes. A refinement with other indicators, more sensitive in the short term, can give a complementary signal to optimize its entry and exit points.