Intra-day traders use various technical indicators to enter and exit trades to profit. They use calculations like moving averages, Fibonacci retracement, stochastic oscillator, Bollinger bands, Relative Strength Index and Super-Trend indicators, among others. Of these, super-trend indicator, developed by Olivier Seban, has been popular for helping investors to spot trades (buy and sell) with precision.
As the name suggests, it indicates the direction of the price movement in a market that is trending, that is following any particular path. It is plotted in stock price charts for investors to see marked current trend which is shown in red when prices have dipped and green when prices have risen.
Super-trend indicator plotted on the price chart of BSE Sensex shown below
How Does Super-Trend Indicator Work?
The super-trend indicator relies on two fundamental dynamic values- period and multiplier. But before we get into that, it is important to understand the concept of ATR or Average True Range. ATR is yet another indicator that gives you market volatility value by decompressing the range of prices of a security for a particular time.
A true-range indicator is the highest of these values (current high minus current low), absolute value (intrinsic value) of the current high minus previous close and the absolute value of the current low minus previous close.
To calculate the ATR, we need to find the series of TR values first, and then divide the above with the number of periods represented by n. This way, you get the moving average of true ranges.
Putting the information above in the formula for ATR, this is how it looks-
TR=Max [(current high –current low), Abs(current high – previous close), Abs(current low – previous close)]
TRi is the true range
n is the number of periods or trading days
This formula is for us to understand the workings behind the indicator. But on most trading terminals, all you need to do is check the super-trend indicator and pick the values for Periods (ATR number of days) and multiplier. A multiplier is a value by which ATR would be multiplied. Usually, traders use ten periods and a multiplier of 3. Shorter values of n can bring up more signals and be more reactive to prices changes. A longer value of n can distil the noise of day-to-day price actions, and there will be fewer signals to act upon.
Buy and Sell Signals
A super-trend indicator is plotted on either above or below the closing price to signal a buy or sell. The indicator changes colour, based on whether or not you should be buying.
If the super-trend indicator moves below the closing price, the indicator turns green, and it signals an entry point or points to buy. If a super-trend closes above, then the indicator shows a sell signal in red.
You will also note that at the point where buy or sell signal is generated is the crossover point. At the point say, buy signal is made and the indicator turns green you will see, on hovering the cursor at this point, the closing price is higher than indicator value. Similarly, when a sell signal is generated, and the indicator turns red, the closing price will be seen lower than the indicator value.
Though initially the super-trend indicator was primarily used by traders in the commodity markets, given its precision that takes into account volatility factor in prices, it became a popular indicator for other securities and asset classes including equities, futures and foreign exchange market.
Support and Resistance
By the very nature of the supertrend indicator, it offers firm support and resistance levels for traders to enter and exit trades. Additionally, it also provides signals for setting stop losses.
The way it works is, for example when the buy signal (green) is on, when prices dip towards the indicator, you can enter or go long at this level, which doubles up as support level. Similarly, when the sell signal is on, in red, price points nearing or touching the indicator can act as levels of resistance.
What is an ideal level to set the stop-loss? If you have gone long, then stop-loss can be set at a level below the green line. If you are planning to take a short position, you can hold on till the prices drop below the level aligned to the red line.
The downside is, a super-trend indicator is more useful in trending markets where there are clear uptrends and downtrends in price. It may not be beneficial when markets are moving side-ways and may throw up false signals triggering wrong trades. For more efficient signals, super-trend is used in combination with other indicators like moving averages and MACD (moving average convergence divergence).