I have come across one of the simplest but most effective trend following indicators, SuperTrend. It stands out as one of the simplest trailing stop indicators that is based on the concept of ATR (Average True Range). It helps traders identify the ongoing market trend while also using a trailing stop method to manage the market risk. In this guide I will break down everything you need to know about the SuperTrend indicator, how it works, the method behind it and the pros and cons of the indicator.
Two basic concepts used in this indicator are Average True Range (ATR) and Trailing Stop Method. We will go through each of these concepts one by one before I explain how the indicator works.
What is the Average True Range?
Average True Range was introduced by J. Welles Wilder Jr. (the same man who introduced RSI) in his book “New Concepts in Technical Trading Systems”. Average True Range is a technical analysis indicator that helps us gauge the volatility of price in the market. In simple words Average True Range shows us the average of the price movement of an asset over a certain number of periods.
Average True Range Indicator is widely used in following cases
- Gauge market volatility
- Set stop loss distance
- Helps create volatility based indicator such as SuperTrend
The formula used to calculate the Average True Range is
TR = max( (High – Low), |High – Previous Close|, |Low – Previous Close| )
High = current period’s highest price
Low = current period’s lowest price
Previous Close = last period’s closing price
Average True Range helps by giving a consistent measure of volatility so the traders can manage the stop loss and take profit depending on the changing market conditions.
I hope the concept of Average True Range is clear by now, let’s move onto the Trailing stop method.
What is the Trailing Stop Method?
Trailing Stop Method or Trailing Stop Loss is a dynamic risk management tool that automatically changes or shifts your stop loss position based on the ongoing trade only when the trade is moving in your favour but never moves backwards.
It can be very hard to watch the market reverse its position and wipe out all or a chunk of your portfolio or a previously ongoing trade but here the trick is to know exactly when to exit the trade safely. This is where the Trailing Stop Method comes into play.
A trailing stop indicator moves your stop loss when the trade is moving in your favor while also giving the trade some room to move, it never moves backwards. This helps traders protect their existing profits on the trade while also keeping themselves in the trade. In contrast to this if you leave your initial stop loss or do not place any stop loss altogether your once profitable trade can turn into loss very fast.
Now that these are out of the way we can move onto the indicator
What is a SuperTrend Indicator?
SuperTrend indicator is a trailing stop indicator that is based on the Average True Range. In this version of the SuperTrend indicator you can change the type of moving average used to calculate Average True Range, either RMA (Running Moving Average) or SMA (Simple Moving Average). The default method being used in this indicator is RMA.
SuperTrend is a very simple and easy to use indicator which can give accurate data about the ongoing trend. It is based on two parameters, period of the Average True Range and its multiplier. The default values used in the SuperTrend Indicator are 10 periods for ATR and 3 as its multiplier.
SuperTrend and ATR
The SuperTrend indicator uses the ATR to calculate its value. This is why we discussed the average true range before as it plays a very important role in this indicator. ATR measures the volatility of the market and helps calculate how far the SuperTrend line should be from the price. If the market is volatile the SuperTrend line will be further away from the price to avoid any false signal and if the market volatility is low the SuperTrend line will move closer to the price.
The buy and sell signals are generated when the indicator starts plotting either above or below the closing price. When the price closes above the previous SuperTrend a buy signal is generated and a green bar is plotted below the moving price. When the price closes below the previous SuperTrend a sell signal is generated with a red bar above the moving price.
SuperTrend also acts as an automatic Trailing Stop, following the price in your favor. If the price is moving up, SuperTrend will automatically move closer to the price locking in your profits. If the price is moving down, SuperTrend moves down as well to lock in the gains of a short position.
