efore we start explaining what the heck those envelopes are and if somebody sends you a love letter in a bottle, we will review what we know about moving averages.
So, the first lesson learned was: By using moving averages we can easily identify changes in the trend.
But the bad news was: Moving averages can be vulnerable to giving false signals.
Then you learn that 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.
“Stop with all this wording already!!”
We know you love examples, so you can see things clearly put into perspective. Here it goes:
EUR/USD is moving upward.
The price closes above a moving average, which means that it is time for an entry to go long.
But we don’t know if the bullish trend is not fake and whether it will continue!
There are two options if you still want to go long:
- Go long, because you believe the original entry signal (price closed above MA)
- Or you could wait to see if the trend is legit.
Now it is time to invite the moving averages envelopes (MAE) to join us.
What are the Moving Average Envelopes?
Yes, we will send you a love letter, but a very important one with clear indications if you need to go long or short.
On a serious note, a moving average envelope is built by a moving average AND two other lines.
There is a line ABOVE the moving average and there is a line BELOW the moving average.
Together, these two lines form an upper and lower envelope.
Moving averages envelopes are used for confirming the trend and identifying the conditions of overbought and oversold.
Overbought is when the price went higher for a short-term period(over its fair value) and it is expected to pull back when the market corrects the price in the near future.
Oversold is when the price went down and the pair is traded under its fair value, so it is expected to bounce.
How to Calculate Moving Average Envelopes
The first thing you need to decide is if you want to use a simple moving average (SMA) or exponential moving average (EMA).
Secondly, you should choose the number of time periods you wish to apply.
Then, you have to set the percentage value for the envelopes.
If we take as an example a 10-day moving average with a 1% envelope, it will be calculated like this:
Upper Envelope: 10-day SMA + (10-day SMA x .01)
Lower Envelope: 10-day SMA – (10-day SMA x .01)
This is a chart of EUR/USD with a 10-day SMA and 1% envelopes.
The blue lines, which are our upper and lower envelope, move parallel with the orange line, which is the 10-day SMA.
They will remain a constant 1% above and below the SMA.
The top and bottom lines are separated from the moving average and their distance is based on the market volatility: the higher the current volatility, the greater the distance.
How to Confirm Trend Direction with Moving Average Envelopes
The moving averages envelope can be used as a trend-following indicator because the direction of the moving average determines the direction of the envelopes.
Therefore, if the envelopes are moving higher, the price is in an uptrend and if the envelopes are moving lower, the price is in a downtrend.
If the envelopes are moving sideways, then it means that the price is neither in an uptrend or downtrend.
But what happens when the price moves above or below the envelopes.
If the price goes above the upper envelope, this could be considered a bullish trend.
If the price goes below the lower envelope, there will be a bearish trend.
Simply, if you want to BUY, the price needs to close above the UPPER envelope.
If you want to SELL, the price needs to close below the LOWER envelope.
Let’s look at the example below:
This is a GBP/USD chart with a 20-day simple moving average (orange line).
You can see that all three of the lines (SMA + the upper and lower envelopes) are moving higher altogether.
The price closed above the moving average, but this is not enough information to know for sure the trend changed to bullish from bearish.
That’s why you need to wait until the price closes above the upper envelope. Then you will have a confirmation that the trend has changed.
How to Identify Overbought and Oversold Levels with Moving Average Envelopes
As we explained in a few paragraphs above, there is an overbought or oversold condition when the price initially moves above or below an envelope but then it pulls back.
This will usually occur if the slope of the moving average is FLAT.
Then, the upper and lower envelope could be considered overbought and oversold levels.
OVERBOUGHT – the price moves above the upper envelope
OVERSOLD – the price moves below the lower envelope
The trap here is that overbought and oversold levels can remain longer than you think if the bullish or bearish trend is strong enough.
CHECK for these two things:
- You should always check the slope of the moving average – is it flat or isn’t.
- You could also get confirmation from the support and resistance levels.
Let’s define the indicators:
Buy Signal – price touches or drops beneath the LOWER envelope level, then it goes back above the lower envelope level
Sell Signal – price touches or rises above the UPPER envelope level, then drops back below the upper envelope level
Below you will see a chart of EUR/JPY, where the 30 SMA and both upper and lower envelopes are flat.
It means that the currency pair has no direction at the moment, it is neither bullish nor bearish.
The upper envelope actually plays out as a strong resistance level.
So, if the price is traded near the upper envelope, it would drop back down.
On the contrary, the lower envelope level acts as a strong support level.
If the price is traded near the lower envelope, it would go back up.
Ok, you got our letter in a bottle, you read it already, so our next stop is moving averages ribbons!