Envelopes

The envelope study is a derivation of the moving average study. The parameters used to compute the study are:-

  • The period, the number of bars used to calculate the moving average, basis the close
  • Percent, a percentage deviation from the moving average 

Calculation

Top Band = * ((100+P)/100)
Bottom Band = MA * ((100-P)/100)

MA = Moving Average basis the close
P = percentage offset

How to use
This indicator needs to be tuned to each individual market, beginning with a Moving Average that needs to be applied to smooth the volatility of the market. The percentage offset then needs to be ascertained so that the bands envelope the previous or recent trading activity. Half the average daily range or a little above is a good starting point, using a daily bar chart. 

The theory is that when the market is stretched to an extreme price, relative to recent activity, it's either trending or about to change direction. In general, the market spends most of the time not trending. It varies from market to market, but as a rule of thumb (basis a half hour chart) markets trend for only about 20% of the time. The rest of the time, about 80% of the time, is spent oscillating within a trading range.

If the market is trending, then it should be obvious or we can use another trend type indicator, like the ADX, to determine this state. If it's not trending then we can assume that as price approaches the top band it will attract sellers and as it approaches the bottom band it will be advertising to buyers. In simple terms we can say that there is a buying opportunity at the lower band and a selling opportunity at the higher band. 

© Copyright 2003 CQG, Inc. All rights reserved worldwide

On the other hand, if it is determined that the market is trending or in a position to start a new trend, then price moving outside the envelope is actually a signal to go with the market. In the example below it is clear that during a trend period, the market price will continually penetrate the leading edge, in this case the top band of the envelope.


 © Copyright 2003 CQG, Inc. All rights reserved worldwide

There are a variety of ways to use some indicators and it really comes down to your own individual style. Indicators are meant to assist and there doesn't appear to be any one indicator that will work all of the time, in every market. The best trading systems seem to be the product of a combination of indicators, with a gross difference between trend following and oscillating indicators. 

This indicator can be tuned loosely to provide sell signal indicator at the top band and a buy signal indicator at the bottom band, in either market state trend or not-trend. It can be tuned tighter to provide just the opposite signal. Issuing a signal to buy a break above the top band and sell a break below the bottom band. Both techniques could provide profitable results, over varying time frames and both techniques would benefit greatly from another indicator, an added filter. More importantly good money management techniques should be employed to prevent potential disaster when using any indicator.

Disclaimer
© The MacLean Group Pty Ltd ACN 096 967 038. All rights reserved 2003. This article has been prepared by The MacLean Group and licensed to ASX. The views are those of the author and not of ASX. This material is educational and it is not intended to constitute financial advice.