- Determine what simple moving average or exponential moving average to use.
Calculate Upper Envelope: N-day SMA + ( N-day SMA x n% )
- Calculate Lower Envelope:
N-day SMA - ( N-day SMA x n% )
Overall trend direction is determined by the chosen moving average. The direction
of the moving average determines the direction of the envelope. When prices are
in an uptrend, the moving average and its envelope will move higher. Conversely
in a down trend the envelope and moving average will move lower. In trendless market
conditions, the envelope and moving average will moves sideways. Price closes above
or below the envelopes after sideway trading ranges signal the potential beginning
of a new trend. A close above the upper envelope can signal the beginning of new
uptrend, while a close below indicates the possible start of a down trend.
When prices are range bound, the moving average envelopes can then be used to identify
overbought and oversold levels. A failure to move prices above the upper envelope
signal overbought conditions, while a failure move below the lower envelope signal
Break out systems perform poorly in range bound markets, but traders who realize
they the market is currently trendless can use the Moving Average Envelope to spot
overbought and oversold levels. When prices fail to break out at the envelopes nimble
traders can take contra trend trades. Failure of prices to remain above the upper
envelope indicates over bought conditions and trader can look to fade the market
or close existing longs. Failure of prices to remain below the bottom envelope indicates
oversold conditions and traders can look to buy or close out existing shorts.
Trend followers can use Moving Average Envelopes to identify new trends or be used
to identify overbought and oversold conditions in range bound markets. Traders need
to experiment to find out what the best time period is use in their moving average
calculation in addition to deciding what percentage the envelope should be. That
answer will depend primarily on what markets you choose to trade and what your time
frame is. Choosing between either using a simple moving average and exponential
moving average will depend on your personal preference.
As with all technical indicators it recommended that you also incorporate other
technical indicators as well as sound money management when you have your capital