Jump to content
  • 0
Sign in to follow this  
Paul Beck

What does an envelope indicator do?

Question

2 answers to this question

Recommended Posts

  • 0
Envelopes are technical indicators that define the upper and lower boundaries of a trading range. The most common envelope is the moving average envelope, which can be based on either a simple or exponential moving average. The envelope is simply a set of parallel lines moving above and below the MA, with the MA at the center. In the example above, the envelope is set around the EMA with a 20-day moving average and a 2.5% envelope, which is the default setting for most charting tools, although you can set your own percentages, typically between 1% and 10%. Envelopes can be used as a lagging trend indicator and to identify oversold or overbought levels in the absence of a trend. Interpreting the envelope can be done in several different ways. The most straightforward is to use it for range trading, signaling a buy when the price pushes inside of the envelope and closes inside it. Conversely, you would short when the price falls through the upper band of the envelope and closes inside. Envelopes can also be used to spot breakouts. In the example above, Tesla broke out of the envelope on October 23rd, and prices gapped well above the 2.5% line, indicating a breakout. Prices stayed well above that point through November 18th, before coming back to rest within the envelope briefly, and resuming the upward trend. The reversal occurred on December 18th, when prices gapped below the envelope for several days before returning briefly to the envelope before sliding back down in mid-January. It’s easy to see in the chart above at which point a trend began by watching the breakouts from the envelope. The theory behind any channel, band, or envelope indicator is that the bulk of a stock’s price action will occur within the boundaries of the indicator, so any move outside the lines should be investigated for potential trades. It should be noted that trading strategy and volatility inform your parameters. If you’re trading, you’ll want a short moving average interval and tight percentages. Investors, on the other hand, will want slower moving averages and a wide envelope percentage. Volatility should also be used to set your percentage parameters. A highly volatile stock needs a wider envelope than one with low volatility. The chart above represents the same Tesla stock, only with the green envelope representing 2.5%, the blue representing a 5% envelope, and the red a 10% envelope. In the first example, the highly volatile stock traded outside of the 2.5% envelope most of the time, but when the envelope was widened to 10%, very few days traded outside the range. In the chart below, the envelopes are set for the same parameters for a relatively low volatility S&P 500 ETF. You’ll notice that prices occasionally penetrate the 2.5% envelope, only bump up against the 5% envelope rarely, and never even approach the 10% envelope. It’s a good idea to play around with your variables, trying both the SMA and EMA, lengthening and shortening the time interval, and adjusting your percentages until you find a chart that suits your investing style. You can also use the moving average envelope to identify overbought and oversold conditions, although this gets a little tricky. In the chart below, a 20-day EMA is drawn with a 5% envelope. You can see sustained periods of time when the stock is trading below the envelope, suggesting an oversold condition, and later, a sustained period outside the upper edge of the envelope, suggesting an overbought condition. You’ll also notice at several points the price hits overbought and oversold resistance. When the envelope suggests Mimecast is oversold, the indicator appeared almost a week before it was confirmed by RSI and a corresponding jump in volume. The same thing happened with the overbought indicator in January, which was confirmed by RSI and a volume spike a short time later. It’s a good idea to combine envelopes with a momentum indicator, such as the RSI, to help identify when a breakout actually indicates the start of a trend, and to confirm overbought and oversold conditions.

Share this post


Link to post
Share on other sites
  • 0

Paul,

The Envelopes indicator is used in technical analysis to determine the upper and lower bands of a trading range. The indicator identifies the range by laying two moving average envelopes on the chart, one shifted upwards and another shifted below. In case the price breaks through one of these bands, it may indicate something and we’d plan our next move.  
 

Share this post


Link to post
Share on other sites

Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account in our community. It's easy!

Register a new account

Sign in

Already have an account? Sign in here.

Sign In Now
Sign in to follow this  

×
×
  • Create New...