Moving Average Envelopes

Introduction

A Moving Average Envelope consists of a moving average plus and minus a certain user defined percentage deviation. Moving Average Envelopes serve as an indicator of overbought or oversold conditions, visual representations of price trend, and an indicator of price breakouts.

The inputs of the Moving Average Envelopes are as follows:

1. Moving Average :

Moving Averages smooth the price data to form a trend following indicator. They do not predict price direction, but rather define the current direction with a lag. Moving Averages lag because they are based on past prices. Despite this lag, moving averages help smooth price action and filter out the noise. The two most popular types of moving averages are the Simple Moving Average (SMA)and the Exponential Moving Average (EMA). These moving averages can be used to identify the direction of the trend or define potential support and resistance levels. A simple moving average of both the highs and the lows can also be used. (generally 20-period is used, but it varies among technical analysts; also, a person could use only the close when calculating the moving average, rather than two)

2. Upper Band:

The moving average of the highs plus a user defined percentage increase (usually between 1 & 10%).

3. Lower Band:

The moving average of the lows minus a user defined percentage (again, usually between 1 & 10%).

In the chart above, the price is not trending. During non-trending phases of markets, Moving Average Envelopes make great overbought and oversold indicators. Buy when the stock price penetrates the lower envelope and closes back inside the envelope.

Sell when the stock price penetrates the upper envelope and then closes back down inside the envelope.

Interpreting Moving Average Envelopes

Price Breakout Indicator

Stock prices breakout when they are done consolidating in a range. When prices break above the upper envelope, then buy.

When prices break below the lower envelope, then sell. An illustration of an upward price breakout is shown above on the chart. On the right side, the script gapped up above the 2% price band.

Price Trend Indicator

A new trend in price is usually indicated by a price breakout as outlined above with a continued price close above the upper band, for an upward price trend. A continued price close below the lower band would indicate a new downward price trend.

In the chart, after the price breakout, the closing price continued to close above the upper band; this is a good example of how a price trend begins. Soon after, the price will fall back into the Moving Average Envelopes, but the Moving Average Envelopes will be heading in a positive direction easily identifying the trend as up.

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