Moving averages can be converted into moving average envelopes, that are used to determine the boundaries of the current price movement. Envelopes are technical indicators that are typically plotted over a price chart with upper and lower bands. Moving Average Envelopes are lines plotted at a certain percentage above and below a moving average of price. The default setting is a 20 period SMA with envelopes set at 5%. They are also known as trading bands, moving average bands, price envelopes, and percentage envelopes.
What are Moving Average Envelopes?
Envelopes of moving averages (MA Envelopes) – are formed by two MAs, capsuling the price on the chart, one of which is shifted up and the other down by a certain percentage (called the envelope ratio).
moving averages determine the upper and lower boundaries of the range of price fluctuations.
The distance by which the shift occurs depends on the market situation and, as a rule, is determined by the selection method.
The optimal value of the shift of the borders of the strip depends on the volatility of the market – the higher it is, the greater the offset value must be set in the parameter.
Sometimes a third line is added – the central moving average from which the displacement occurs.
The top line of the envelope:
Moving Average Upper Band = MA + (K / 100) x MA,
(K is the percentage of the price by which the moving average moves up).
The bottom line of the envelope:
Moving Average Lower Band = MA – (N / 100) x MA,
(N is the percentage by which the moving average shifts down).
Envelopes can be built based on any kind of moving average – simple, balanced, smooth, and exponential. However, they often use a simple moving average.
The primary interpretation of the indicator is that the price, after some fluctuations, returns to its main trend (to its midline of the moving average).
The more the price deviates from its main tendency, the greater the number of market participants may take profits, returning the price to normal. However, this can be observed more often when the price moves in a trend.
The greater the volatility of the analyzed market, the higher the border bands should be chosen.
How to use Moving Average Envelopes?
This indicator is part of the standard MetaTrader 4 terminal indicator set. In the indicator settings, you can set the MA, its period, and the percentage of deviation, which is manually selected so that the lines compress the price.
After selecting the deviation, the upper line is used as a resistance line and the lower one as a support line.
You can also display the midline by setting the level value to 0. You can try 0.5, 1.0 or anything else to check what suits your trading strategy.
Moving Average Envelopes trading strategy
Envelops can be used as bands around price action that signify overbought and oversold levels and can also be used as price targets. Many traders consider Envelopes a variation of Bollinger Bands. The basic principle of both tools is the same: after any fluctuations, the price will always return to the main trend.
An upward direction of the envelops would confirm a bullish trend, while a downward slope will portray a bearish movement in the trend. Traders can identify alerts for the potential formation of a new trend or changes in trend direction by looking at the price and the envelope bands.
You can create a variation of trading strategies based on the envelope indicator. We are discussing a common method below:
Look at the chart and be alert when the price hits or crosses lower or upper band. A sell signal comes when the price reaches the upper line, a buy signal when the price approaches the lower line. Have a look at the following chart of XAUUSD:
This is a buy setup as the price approached the lower band and found rejection. You may buy if the candle closes near the high.
The above chart shows potential sell signal as the price approached the upper band and the candle closed near the low.
But often envelopes give false or very late trading signals. Therefore, it is useful that the signal is confirmed by other technical analysis indicators, price action, fundementals, market sentiment, etc.
Placing stop-loss and take-profit
You could use the nearest support and resistance levels to identify potential levels for placing stop-loss and take-profit. If the swing area (stop-loss zone) is too far then you may refrain from trading as this could hurt the risk-reward ratio.
Moving Average Envelopes conclusion
Moving average envelope is a technical analysis indicator, showing lines above and below a moving average. The starting point is a simple or exponential N-period moving average which is calculated as the average of the stock price for each of the previous N periods (usually days).
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.
Like any other trading indicator, you should be cautious while using moving average envelope alone because there could be false signals that you may need to filter with further market analysis. You can use different variations in period, shift, deviation and level to find what suits your preferred trading strategy.
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