Technical Indicators IV: Moving Average Envelopes

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The moving average envelope is a variant application to the moving average. It is a trading band composed of two moving averages, which attempts to determine the range of market should be trading in. Traders can choose their period of MA, then form the upper line of the envelope by shifting the MA upwards and the lower line of the envelope by shifting the MA downwards.

The reasoning behind the envelope is that moving averages define the general trend of the market and are the best-fit line to the recent movement of the price. Most of the data should appear close to the moving average lines. The envelopes define a range away from the moving average that the price should return to the center in a short term if the price strays too far away from the moving average. Therefore, the envelopes are best to identify potential reversals when the price hits the envelope boundaries.

On a daily chart, it is common to use 21-day Simple Moving Average and form the envelopes with 2% or 3% above and below the 21 day SMA. For longer term trading, traders can choose longer time frame like 50-day SMA and larger percentage variation like 5%.

In the above chart, you can see prices stay within the 3% band most of the time. When the price hits the boundary of the envelopes, it is a sign of reversal. Somehow the price returned to the centerline and move on again. However, traders are reminded that not every signal is valid. When the trend is strong enough, it can raise (or fall) along the envelope boundary resulting many false signals.