Envelopes, a trend following indicator
Channels moving averages or Envelopes (Moving Average Envelopes) are channels whose lines, upper and lower are calculated as a deviation percentage of a simple moving average or exponential moving average. Each line is at the same percentage above and below the central moving average. This creates two parallel strips that follow the price action. This technical indicator can be used as a trend-following indicator because they are based on moving averages. However, the use of this indicator can be extended to identify overbought and oversold areas where the trend is relatively flat.
Let`s see in this article how to use this indicator to analyze financial market assets, especially Forex.
Calculation of Envelopes
The Envelopes calculation is easy. Simply calculates a simple moving average or exponential moving average (this is at the trader’s choice) of a certain period (to learn how both moving averages are calculated please see the Moving Averages article). The second step is the calculation of a percentage on this moving average and subtracting and adding it to obtain the lower and upper band of the indicator.
The envelopes constructed with a simple moving average of 14 periods and a deviation of 30% would give the next channel on the following price chart:
Interpretation of the indicator
Like other indicators based on channels and bands (such as Bollinger Bands, Keltner Channels, etc), the Moving Average Envelopes are designed to contain most of the price action. Therefore, movements above or below the lines forming the envelopes are not normal but are situations that should catch our attention. If the price goes beyond the limits of the indicator that means that the market must be very strong, either in an uptrend or a downtrend and, therefore, these are moments that may mark the end of a trend and the beginning of another in the opposite direction.
As we said at some point before the envelopes are a trend-following indicator and are based on a moving average. The direction of the moving average will determine the direction of the channel and therefore the direction of the trend. Thus we can say that we are in a bullish market when the channel is tilted upward or in a bearish market when the channel is inclined downward. The market does not have a definite trend when the channel has an almost flat slope.
Configuration of Moving Average Envelopes
The parameters chosen when configuring the Envelopes indicator depend largely on the characteristics of the asset but also on the trading style of the analyst. For example, a short-term trader should use as a base a short-period moving average (a faster MA) and narrower bands than an investor or trader that invests in a longer term.
Among the characteristics of the analyzed asset that most influence the choice of Envelopes parameters the most important is the volatility. Both Bollinger bands and Keltner Channels have adjusted automatically to the volatility (Bollinger bands by using standard deviation and Keltner channels by the use of ATR) but with the Envelopes, the volatility must be analyzed independently when the settings of the indicator are set. Thus, narrower bands are used in assets with low volatility while wider bands are used in assets with higher volatility always bearing in mind that the aim is for Envelopes to cover the majority of price action.
To choose the best configuration of Envelopes we can put different Envelopes in the chart, each one with different moving averages and different amplitude, and compare the result with each. In the picture above we can see a chart for the USD/JPY which have 3 Envelopes based on a simple moving average of 14 periods which are increasingly wider with a deviation of 20, 30, and 40%. The Envelopes of 20% (yellow) were reached on numerous occasions, the Envelopes of 30% (red) were reached less frequently, and the Envelopes of 40% (blue) were rarely reached (only at times when the market was very volatile). Comparing the behavior of this currency pair and the three different configurations of Envelopes, a medium-term trader should choose to use Envelopes of 40% while a trader with short-term strategies should choose Envelopes of 30%.
Trend Identification with Envelopes
The Envelopes can be used to detect possible signals indicating the beginning of a trend. As in other channel type indicators such as Keltner Channels, at the beginning of a trend, strong movements are produced, and these movements will make the price go out of Envelopes bands alerting the possible start of a trend phase.
In the picture above can be identified different points where the market changes its trend after the price goes through the Envelopes. The price came out of the channel indicating the start of the trend. During the development of a trend, we can use different oscillators such as the CCI (Commodity Channel Index) or the Stochastic along with some chart patterns such as channels of flags in order to obtain buy and sell signals after pullbacks (at this point may be interesting to read the article: Trading the trends in the Forex market). For example, we can open a buy position when the CCI indicates an oversold market, then returns into positive territory and the price returns to the Envelopes channel after crossing the lower band.
Identification of overbought /oversold zones
Following the thread of the previous point, with the Envelopes indicator is possible to identify overbought and oversold zones. However, you may have noticed that an active zone can stay overbought or oversold for an extended period of time, using either Envelopes or any other indicator (novice traders fall into the trap of opening a position immediately in these areas). That is why overbought/oversold areas should be used as trading signals only during periods of flat market trend.
For example, during a strong uptrend the price may go up on the top line of Envelopes and stay on it for some time, this is technically a state of an overbought market but nevertheless is a signal of a strong trend too. Therefore, I repeat, the identification of overbought/oversold areas should be used during periods of flat trend.
In the next picture, you can see this principle in action. When the price goes up on the top line of Envelopes and remains on it we see that there is a trending period while during the period of flat market trend (a market without a clear trend), the values of overbought/oversold conditions can be taken properly as signals for possible changes in the price trend.
More information on technical indicators and other tools in: Technical analysis in Forex trading
