Moving Average Envelope

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Introduction

Many trend following systems are based on some form of break out strategy, such as a channel breakout or volatility break out system. The idea is that new trends will typically begin after breaking out of some period of consolidation in prices. Traders can spot breakouts using tools such as Bollinger Bands, Keltner Channels or Moving Average Envelopes. Let’s take a look at Moving Average Envelopes since Bollinger Bands and Keltner Channels are essentially based on many of the same principals of Moving Average Envelopes.

Trading with Moving Average Envelopes all begin with the basic idea that prices will trend with a central value acting as magnet for prices. This central value can be identified with either a simple or exponential moving average. As prices move over time, prices will gravitate around that moving average some time above and other time below its central value. By creating bands or envelopes around a moving average, traders can better determine the range in which price are expected to move. Moving Average Envelopes are used spot the beginning of new trends or identify overbought and oversold levels.

Percentage Envelopes

Moving Average Envelopes are typical based on a fixed percentage set above and below a moving average. Each envelope is set with the same percentage above or below the moving average creating parallel channels that follow price action.

The outer bands are used as the trigger for signals to identify the new trends. The tricky part with Moving Average Envelopes is that the percentage used in the for the envelopes need to be large enough that it accounts for most of the normal price movement around the moving average during trendless periods to reduces false signals, yet be small enough to signal when a new trend has began. One of the major criticisms with fixed-percentage envelopes is that they do not adjust for the changing volatility of prices.

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Calculation

  1. Determine what simple moving average or exponential moving average to use.
  2. Calculate Upper Envelope: N-day SMA + ( N-day SMA x n% )
  3. Calculate Lower Envelope: N-day SMA - ( N-day SMA x n% )

Interpretation

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 oversold conditions.

Overbought/Oversold

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.

Conclusions

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 at risk.