What are moving average envelopes?
Let’s rewind and briefly talk about moving averages first.
The goal of using moving averages is to identify trend changes.
While moving averages are a useful tool to have in your technical analysis toolbox, they can be susceptible to providing false signals.
Like you’ve learned in 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.
For example, let’s say EUR/USD is moving upward and closes above a moving average, signaling an entry to go long.How do you know that this bullish trend is “real” and will continue?
You don’t.
So assuming you still want to go long, you have two options:
- Go long now based on the original entry signal (price closed above MA)
- Wait for more confirmation that the trend is legit.
This is where moving averages envelopes (MAE) can help.
Huh? Moving average envelopes?
Like this?
No, not that kind of envelopes.
What are Moving Average Envelopes?
A moving average envelope consists of a moving average AND two other lines.
One line is ABOVE the moving average and the other line is BELOW the moving average.
Together, these two lines form an upper and lower envelope.
It’s called an envelope (noun) because these two lines envelope (verb) the original moving average line.
Moving averages envelopes are used to:
- Confirm trend
- Identify overbought and oversold conditions
How to Calculate Moving Average Envelopes
How to calculate a moving average envelope is pretty simple.
First, decide whether you want to use a simple moving average (SMA) or exponential moving average (EMA). Remember, 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 you’d like to use for the envelopes.
For example, 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 Lower Envelope: 10-day SMA - (10-day SMA x .01)
The chart below shows EUR/USD with a 10-day SMA and 1% envelopes.
Notice 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 be used as a trend-following indicator.
The direction of the moving average determines the direction of the envelopes.
When the envelopes are moving higher, the price is in an uptrend.
When the envelopes are moving lower, the price is in a downtrend.
When the envelopes are moving sideways, the price is neither in an uptrend or downtrend. The trend is neutral and the price is considered directionless.You should pay attention when the price moves above or below the envelopes.
Since trends often begin with a strong move, if the price surges above the upper envelope, this is considered bullish.
If 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, notice 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 changed 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 also be times when the price initially moves above or below an envelope but turns back around.
This usually happens when the moving average slope is FLAT.
When this happens, moving average envelopes can be used to identify overbought and oversold levels.When the price moves above the upper envelope, this can be considered overbought.
When the price moves below the lower envelope, this can be considered oversold.
Identifying overbought and oversold levels isn’t easy though.
Remember, a currency pair can become overbought and remain overbought when the bullish trend is strong.
The same goes 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 best to pay attention to the slope of the moving average and make sure it’s flat.
You should confirm overbought and oversold levels with support and resistance levels.
Buy Signal
If price touches or falls beneath the LOWER envelope, then rises back above, buy.
Sell Signal
If price touches or rises above the UPPER envelope, then falls back below, sell.
Example: EUR/JPY
In the chart below, notice how the 30 SMA (orange line) and the upper and lower envelopes (blue lines) are flat…almost horizontal even.
EUR/JPY is directionless here. There is no strong bullish trend, nor is there a strong bearish trend.
Observe how the upper envelope acts as a strong resistance level.
Whenever price traded near the upper envelope, the price would fall back down.
The same with the lower envelope. Observe how it acts as a strong support level.
Whenever price traded near the lower envelope, the price would bounce back up.
Summary
Moving average envelopes (MAE) are used as a tool to confirm trend direction, but can also be used in sideways markets to identify overbought and oversold levels.