Abstract：Moving averages (MA) are a popular trading tool. Unfortunately, they are prone to giving false signals in choppy markets. By applying an envelope to the moving average, some of these whipsaw trades can be avoided, and traders can increase their profits. Envelopes trading has been a favorite tool among technical analysts for years, and incorporating that technique with MAs makes for a useful combination.
Moving averages (MA) are a popular trading tool. Unfortunately, they are prone to giving false signals in choppy markets. By applying an envelope to the moving average, some of these whipsaw trades can be avoided, and traders can increase their profits. Envelopes trading has been a favorite tool among technical analysts for years, and incorporating that technique with MAs makes for a useful combination.
What are moving average envelopes？
Moving Average Envelopes are lines plotted at a certain percentage above and below a moving average of price. Moving average envelope is a technical analysis indicator, showing lines above and below a moving average. The goal of using moving averages or moving-average envelopes is to identify trend changes
As youve learned in the previous lessons on moving averages, a simple buy signal occurs when prices close above the moving average. And a simple sell signal occurs when the price closes below the moving average.
Example, assuming EUR/USD is moving upward and closes above a moving average, alarming a signal of an entry to go long. How do you know that this bullish trend is “real” and will continue？, possibly you dont.
So assuming you still want to go long, you have two options:
This is where moving averages envelopes (MAE) can play a role. But moving average envelopes Like this？.. no, not such kind of envelopes.
Its called an envelope (noun) because these two lines envelope (verb) the original moving average line.
Traders can use moving averages envelopes to:
How to Calculate Moving Average Envelopes
A simple moving average is calculated by adding the closing prices of a stock over a specified number of time periods, usually days or weeks. Calculating moving averages envelopes is simple,
First, you need to decide whether you want to use a 7simple moving average (SMA) or exponential moving average (EMA). Note that, EMAs have less lag because they put more weight on recent prices.
Then, select the number of time periods you wish to apply.
Lastly, set the percentage value youd like to use for the envelopes. As an example, a 10-day simple moving average is calculated by adding the closing prices over the last 10 days and dividing the total by 10.So for a 10-day moving average with a 1% envelope would show the following lines:
Upper Envelope:10-day SMA + (10-day SMA x .01)
10-day SMA
11-Lower Envelope:10-day SMA - (10-day SMA x .01)
The chart below shows EUR/USD with a 10-day SMA and 1% envelopes.
Observe carefully how the envelopes (blue lines) move parallel with the 10-day SMA (orange line).
They remain a constant 1% above and below the moving average (orange line).
How to Confirm Trend Direction with Moving Average Envelopes
Since the foundation of moving average envelopes (MAE) is the moving average, this means that the moving average envelopes can also be used as a trend-following indicator.
The direction of the moving average determines the direction of the envelopes.
If the envelopes moved higher, than the price is in an uptrend.
But the envelopes are moving lower, the price is in a downtrend.
In the case where the envelopes are moving sideways, the price is neither in an uptrend or downtrend. The trend is neutral and the price is considered directionless. Therefore You should pay attention when the price moves above or below the envelopes.
Because the trends often begin with a strong move, if the price surges above the upper envelope, this is considered bullish. And when the price plunges below the lower envelope, this is considered bearish.
Buy Signal
If the price closes above the UPPER envelope, buy.
Sell Signal
If the price closes below the LOWER envelope, sell.
Example: GBP/USD
In the chart below, observe how the 20-day simple moving average (orange line) and the upper and lower envelopes (blue lines) are moving higher.
See how the price managed to close above the moving average.
To confirm that the trend has shifted from bearish to bullish, you could wait until the price has also closed above the upper envelope.
How to Identify Overbought and Oversold Levels with Moving Average Envelopes
There will be time also when the price initially moves above or below an envelope but bounce around. But it usually happens when the moving average slope is FLAT.
And When this occurs, we can use moving averages envelopes to identify overbought and oversold levels.
When the price moves above the upper envelope, this can be considered overbought. Otherwise this can be considered oversold. Though it is not easy identifying overbought and oversold levels.
Recall, a currency pair can become overbought and remain overbought when the bullish trend has more power. The same applies for being oversold. In a strong bearish trend, something can be technically oversold, but remain oversold for quite some time.
This is why it‘s good to pay attention to the slope of the moving average and make sure it’s flat. So you should also confirm overbought and oversold levels with support and resistance levels.
Buy Signal
If price touches or falls under the LOWER envelope, then rises back above, then you buy.
Sell Signal
If price touches or rises above the UPPER envelope, then falls back below, then you sell.
Example: EUR/JPY
In the chart below, observe how the 30 SMA (orange line) and the upper and lower envelopes (blue lines) are flat almost horizontal even.
Here EUR/JPY has no direction which means There is neither strong bullish trend, nor a strong bearish trend. Observe how the upper envelope acts as a strong resistance level.
Anytime price traded near the upper envelope, the price would fall back down.
Also The same with the lower envelope. Observe how it acts as a strong support level. Anytime price traded near the lower envelope, the price would rebound back up.
Summary
Moving average envelopes (MAE) are used as a tool to confirm trenddirection, but at the same time it can be used in sideways markets to identify overbought and oversold levels.
