Moving average envelopes are what they sound like.
Let’s take a step back and speak about moving averages briefly first.
Moving averages are used to identify trend changes.
Moving averages are a helpful tool to have in your technical analysis toolbox, but they can provide erroneous indications.
A basic buy signal happens when prices close above the moving average, as you’ve taught in earlier classes on moving averages.
When the price closes below the moving average, a simple sell signal occurs.
For example, suppose EUR/USD is rising and closes above a moving average, giving a buy signal.
What evidence do you have that this bullish trend is “genuine” and will continue?
No, you don’t.
So, if you still want to go long, you have two choices:
1. Go long now based on the original entry signal (price closed above MA)
2. Wait for more confirmation that the trend is legit.
This is where moving averages envelopes (MAE) can help.
What are Moving Average Envelopes?
A moving average envelope is made up of a moving average as well as two additional lines.
The first line is ABOVE the moving average, while the second line is BELOW the moving average.
These two lines combine to produce an upper and lower envelope.
The term envelope (noun) refers to how these two lines envelope (verb) the initial moving average line.
Moving average envelopes are used for the following purposes:
Confirm trend
Identify overbought and oversold conditions
How to Calculate Moving Average Envelopes
To begin, determine whether you want to use a simple moving average (SMA) or an exponential moving average (EMA) (EMA).
Remember that EMAs have less lag since they place a greater emphasis on current prices.
Then, specify the number of time periods to be used.
Finally, enter the percentage amount you want to use for the envelopes.
A 10-day moving average with a 1% envelope, for example, would provide the following lines:
Upper Envelope: 10-day SMA + (10-day SMA x .01) 10-day SMA Lower Envelope: 10-day SMA - (10-day SMA x .01) The EUR/USD chart below shows a 10-day SMA and 1% envelopes.
Notice how the envelopes (blue lines) move parallel with the 10-day SMA (orange line).
They remain a constant 1% above and below the moving average (orange line).
How to Confirm Trend Direction with Moving Average Envelopes
Because the moving average is the foundation of moving average envelopes (MAE), the moving average envelopes can be utilized as a trend-following indicator.
The direction of the envelopes is determined by the moving average.
The price is in an uptrend when the envelopes move higher.
The price is in a downtrend when the envelopes move lower.
When the envelopes go sideways, the price is neither rising nor falling. The price is termed directionless because the trend is neutral.
When the price rises above or below the envelopes, you should pay notice.
Because trends frequently begin with a significant move, a price rise above the top envelope is considered bullish.
If the price plunges below the lower envelope, this is considered bearish.
Buy Signal
If the price closes above the UPPER envelope, buy.
Sell Signal
If the price closes below the LOWER envelope, sell.
Example: GBP/USD
Notice how the 20-day simple moving average (orange line) and the upper and lower envelopes (blue lines) are rising in the chart.
Notice how the price closed above the moving average?
You might wait until the price closes above the upper envelope to confirm that the trend has shifted from bearish to bullish.
How to Identify Overbought and Oversold Levels with Moving Average Envelopes
There will also be moments when the price moves above or below an envelope but then reverses direction.
This is common when the moving average slope is FLAT.
When this occurs, moving average envelopes can be used to determine overbought and oversold levels.
When the price climbs above the upper envelope, it is called overbought.
When the price falls below the lower envelope, it is deemed oversold.
However, identifying overbought and oversold levels is difficult.
When the bullish trend is strong, a currency pair can become and remain overbought.
The same is true for being oversold. In a strong bearish trend, something can be technically oversold but remain oversold for a long time.
This is why it’s critical to monitor the slope of the moving average and ensure it’s flat.
Overbought and oversold levels should be confirmed with support and resistance levels.
Buy Signal
If the price touches or falls beneath the LOWER envelope, then rises back above, buy.
Sell Signal
If the price touches or rises above the UPPER envelope, then falls back below, sell.
Example: EUR/JPY
Notice how the 30 SMA (orange line) and upper and lower envelopes (blue lines) are flat in the chart. It’s almost horizontal.
EUR/JPY is pointing nowhere. There is neither a strong bullish nor a strong bearish trend.
Take note of how the upper envelope functions as a strong resistance level. Whenever the price was near the upper envelope, it would fall back down. The lower envelope is the same. Take note of how it functions as a significant degree of support. When the price was at the bottom envelope, it would bounce back up.
Next Lesson: How to Analyze Trends With Moving Average Ribbons
