Sure, moving averages work excellently as technical indicators by themselves, but why not use them in pairs? That must be what traders were thinking when they invented moving average envelopes for technical analysis. Moving average envelopes are known simply as “envelopes” in trading platforms like Metatrader 4 or TradeStation.
Traders use envelopes to find overbought and oversold price levels. Each envelope is comprised of two major pieces, defined in the indicator settings:
- Upper envelope band – The upper band is comprised of a moving average of the highs for periods with a percentage shift up. Set between 1 and 10%, the upper envelope band’s shift makes sure the upper envelope is almost always above the current price.
- Lower envelope band – The lower band is a moving average of the lows for each bar or candlestick period shifted down by a range of 1-10%. The price is almost always above the lower envelope band.
Moving Average Envelopes in MT4
You can see below how envelopes appear on a chart of the EURUSD:
Trading Envelopes
Traders can use envelopes to make trading decisions. Most commonly, traders seek out overbought or oversold levels defined by a rise above or below the upper or lower band. If the price were to dip below the lower band, then the trader would long the pair after a rise above the lower band. If the price were to rise above the upper band, the trader would go short as the price crosses back through the band.
Traders who modify the envelope indicator settings can use moving average envelopes to find momentum trades, as well. Using the envelope as a momentum indicator means that a trader would buy on a cross above the upper band, and sell on a move below the lower band. Remember to set the envelopes with new settings; most traders use 2% for momentum trading. Setting the envelopes too high will generate losing trades; setting it too low will trigger too many trades, most of which end up unprofitable.
Short-Term Indicator
Each technical indicator has its own personality, and envelopes are no exception. This indicator works best for short-term trading where large movements are statistically less likely. Using the envelope indicator for long-term technical trading often creates far too many buy and sell signals to be used profitably. Remember, in the long-term, very large movements are the norm, not the exception. Traders interested in using envelopes as a long-term indicator should use it for momentum, not as an oscillator.
Moving Average Envelope Calculation
Those who wish to explore the envelope indicator fully will want to know about the technical indicator’s function. The equation below describes how the indicator is calculated:
Upper Band = SMA(CLOSE, P)*[1+(K/100)]
Lower Band = SMA(CLOSE, P)*[1-(K/100)]
SMA = Simple Moving Average
P= Periods
K= Percentage change expressed as a whole number percentage (36%=36)
