In the past few years, the Supertrend Indicator (created by Oliver Seban) has become more popular given the success people are having. We use it as well, as a Trailing Stop, but there is much more to the Supertrend than meets the eye.
So read on, and find out the various applications of the Supertrend and how it can help you enhance your trading.
The Essence of the Supertrend
The Supertrend formula is quite simple to understand, and is based on the concept of ATR. Essentially the Supertrend adds and subtracts a multiple of ATR from the median price [(today’s high + today’s low)/2]:
- UpBand = median price + (multiplier*N-period ATR)
- DownBand= median price – (multiplier*N-Period ATR)
The standard settings are 3 for the multiplier and 10 for the ATR period. If the current trend is down and price closes above the UpBand, it would suggest a change of trend and the DownBand now becomes both the trailing stop on and the trend change point, combined into one indicator.
So the Supertrend is essentially a trend-following indicator, with the additional benefit of being adaptive to current market conditions via the ATR factor.
How ATR Defines a Trend
The detail we like about the Supertrend is the inclusion of ATR, because it is directly connected to the concept of “momentum”: market participants are constantly absorbing and digesting the flow of fundamental data and local dynamics from the various regional economies. Most of the time, participants are able to react in time, and the prices we see on our charts remain rather “dull”. This is when trading becomes “technical”, because markets have reached some form of “temporary fair value” and are rangebound or just moving without any determination.
However, when the market receives a shock, or dynamics change and participants need to radically alter their positions, then you witness strong movements. This is what happened in the recent past with the Loonie. With last-moment NAFTA progress, alongside decent data on Friday, the Canadian Dollar has changed trend by closing below the UpBand.
These boosts in momentum are significant, because they usually mean the market has been pushed out of balance and needs to now find a new balance, given the information that caused the shock. Up to a certain point, the fundamental reasons for the shock may elude us. We might be able to understand part of the story, but we will never really understand the whole story.
What we can do, instead, is measure the impact of the shock and attempt to follow the move for as long as it will go. The logic was also decribed by Adam Grimes with his “Sigma Spike” indicator, which essentially tells a trader the volatility of the current day’s action, and highlights days that go beyond 2 standard deviations (which would also pop up as Bollinger Band Breakouts).
The ATR included in the Supertrend does something similar. ATR measures the amount of space an asset usually moves over a given time frame. In order to capture these price shocks, let’s arbitrarily say that any move larger than 3*10-Day ATR is significant. The Supertrend adds this volatility component to the current median price and hence dictates that only a certain amount of movement can actually change the stance.
There has been one interesting study done on the Supertrend, in which the authors wanted to verify parameter robustness on various currency pairs. In this study, they analyzed the influence of the parameters “multiplier” and “window size” of the
Super‐Trend indicator and tested almost 10,000 parameter pairs on the 12 principal forex currency pairs for a time frame of about 12.5 years.
Any parameter settings that yielded a draw‐back of more than 30% or a single loss of 10% or more were noted as “failed”.
Simulated trading was based on opening an order upon a trend‐change and closing it on the next trend change i.e. every time a signal of the Super‐Trend indicator was issued. Here are some results from the study:
Here is a visual representation of the robustness check in EurUsd (Daily) and EurChf (Daily):
I’m against optimization for a number of reasons. But what the authors found out, in doing this test, is influential as it gives as information on the particular behaviour of different currency pairs:
- Smaller Multiplier & Window sizes denote more trendiness in the data;
- Larger Multiplier & Window sizes denote more rangebound conditions in the data.
Similar conclusions were found many years ago by Citigroup in this study.
Basically the key is to know how much any market “trends” and how often it remains in a range. EurUsd and UsdJpy are definitely trending instruments and are a good match for the Supertrend as a standalone model. But other currency pairs like UsdCad or EurChf or EurGbp just don’t have the same properties and hence require a more hands-on approach.
Using Supertrend as a Trend Filter
One way to avoid parameter optimization is to use common sense: select volatile, trendy instruments and use the Supertrend as a “trend filter”. Then, use a tad of price-action to enter after the market has pulled back, without changing the trend.
In the example above we have used a simple Stochastic Oscillator to highlight overbought/oversold readings which, coupled with typical candle prints highlighting exhaustion, can indicate a near-term change in sentiment which we can then use to get into the trend once more.
Then it’s up to your trade management to do the rest of the work (but that’s beyond the scope of this article).
Over to You
Many traders get caught up in parameter optimization. This is not efficient. The key is to logically think about what you’re looking at. ATR measures movement. How much movement do YOU want to see, before it becomes significant? And what lookback period do you want to refer to? Work with the numbers, learn how they react, and create something YOU can totally trust.
At the end of the day, the Supertrend is simply another trend-following indicator and must be treated as such. It is useful in highlighting strong mometum shifts, which can give birth to new and lasting trends.
About the Author
Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.
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