The majority of indicators either give lagging signals or are susceptible to providing false positives during choppy markets in today’s volatile financial markets. A trader is constantly searching for that indicator that may help him or her gain the largest possible gains while risking minimum amounts and thus avoiding large drawdowns.
a trend-following tool that uses the connection of price action and volatility to determine overall market sentiment. One of the tools promising traders the best opportunities for entry and dropping out to maximize profits and minimize risk.
We will discuss in this article how the Supertrend Indicator can be applied in a trading strategy and shown to generate a profit with actual rules and backtested performance, as well as how it helps achieve superior risk-adjusted returns over time.
What is the Supertrend Indicator?
The Supertrend Indicator is a trend following tool generating buy and sell signals from the position of price relative to its indicator line. This calculation takes the median price and incorporates the average true range, or ATR, in order to adjust for market volatility. The entry, when the price crosses above the indicator, represents a buy signal because it is moving up. Conversely, the entry where the price breaks below the indicator signifies a sell or reversal trade because it is signaling a downtrend.
How to Calculate Supertrend Indicator
It calculates the median price, average of high and low of a period of time, then add or subtract the ATR of a selected look-back period. Though the indicator utilize two bands the upper and lower, the Supertrend indicator focuses on a single signal line, which switches between the two bands where price crosses the value of the Supertrend indicator, which means yet another trend reversal.
This can be written out as such:
- Median Price = (High + Low) / 2
- Upper Band = Median Price + (Multiplier * ATR)
- Lower Band = Median Price – (Multiplier * ATR)
As the closing price of a bar crosses its value from the preceding period, Value of the Supertrend Indicator changes to the lower band from the upper band (or vice versa).
Supertrend Indicator: A Trade Example
For example, this Supertrend trade in the S&P 500 triggered a buy signal on 29 May 2020 at 3044. Sell signal came on 21 January 2022 at 4397. The return was around 44%. This example proves the catch of an important uptrend and how to exit a position before the major drawdowns, providing a useful risk-management tool.
Supertrend Indicator Strategy
Rules for Trading:
- Long Entry: When the price penetrates above the Supertrend line, the long position is initiated.
- Short Entry: It sells or flips the position short when the price penetrates below the Supertrend line.
This strategy can be applied to any type of timeframes. However, it works really well on longer timeframes-for example, the weekly chart- because it is a trending indicator. Here we use:
- A 10-bar look-back.
- A 3 ATR multiplier for volatility adjustment.
You are perfectly free to modify these as you prefer, but it is always a good idea to backtest any modifications before carrying them out into a live trading environment.
Backtest Results: S&P 500
We ran a backtest of the S&P 500 from 1960 to the present day using the following inputs:
- Weekly data
- A 10-bar look-back.
- A 3x ATR multiplier.
Key Performance Metrics:
- Number of Trades: 38 trades since 1960.
- Annualized Return: 6% (excluding dividends).
- Drawdown: 24% to a buy-and-hold strategy’s drawdown of 56%.
- Time Spent in Market: 63% at reduced exposure during periods of greatest risk.
Annualized returns when adjusted for the time spent in the market provide a risk-adjusted return of 9.4%, more than 30% higher than a buy-and-hold strategy’s risk-adjusted return of 7%.
Benefits of the Supertrend Indicator Strategy
- Catch of trend: It has excellent catch of major trends that can enable traders to seize higher profits in trading and avert choppy markets.
- Lower Drawdown: Supertrend strategy is likely to experience much fewer drawdowns based on backtesting during any period as compared to a standard buy-and-hold strategy. This is particularly well-suited for risk-averse investors.
- Ease of Use: There is nothing complicated about the trading rules: buy when the price is over the indicator and sell when it is in the opposite situation. No long and complex calculations or multiple indicators to follow.
Drawbacks of Supertrend Indicator
- Better on Longer Time Frames: While Supertrend Indicator does just fine across shorter periods, the functionality of the indicator is better on a long period chart. Only traders targeting short-term trades will not benefit much.
- Few Trades: In our backtest, there were only 38 trades over more than 60 years. That might be a disadvantage for traders who like more action.
Conclusion
And as the name would suggest, it is just simple yet effective for the identification of trends as well as effective risk management. It has generally avoided significant drawdowns and delivers risk-adjusted returns over time, so it is great for long-term traders. Still, it’s not without its limitations: mainly suited for long-term usage and infrequent trading signals.
It should be backtested using various parameters to see if it fits your trading style and acceptable risk level to fully exploit the potential.
For the interested reader, the code of the indicator can be accessed from our linked page to experiment and tune it to their advantage.