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Moving Average Envelope

Envelope indicators are widely used in technical analysis. They are also called channel indicators. Moving Average Envelope represent one of the interpretations of a channel approach.

The main idea is that prices form so-called channels during trends. Support and resistance trend lines are useful in terms of pointing to entry levels and highlighting possible retracement depth. However, trendlines are static even if they are ascending or descending. Therefore, technical analysts faced a task to develop a dynamic channel indicator, which would move support and resistance lines in accordance with the trend’s strength. For example, if an uptrend momentum increased, and prices started moving higher faster than previously, then the support line should be shifted higher for a larger distance then a straight trendline.

Of the indicators to solve this issue is moving average envelope.

What is the Moving Average Envelope?


MAE is a simple moving average with two additional lines above and below, shifted to a fixed range. Settings of the indicator include the period of the mainline and a percentage of the shift. For example, a simple moving average with a period of 20 bars and two lines with a 1% shift from the main value above and below will form the envelope.

The envelope indicator is placed on the price chart and it looks like this:

Moving Average Envelope

In contrast to the most widely-used envelope indicator - Bollinger Bands, the moving average envelope has a fixed distance between the upper and the lower line. Therefore, three moving averages would not reflect periods with high volatility, as they would only show the direction of the price change. Other metrics and signals are the same as per Bollinger Bands. The range between the upper and middle line is called the bullish channel, while the bearish channel is placed between the middle and lower lines. Breakout and reversal signals are still in place when the price breaks through the upper or the lower line. All of the three curves might be used to determine support and resistance levels. The only difference is that strong trends would have a longer time of the price outside the channel.

Best settings for the moving average envelope depend on the chosen asset, its volatility and liquidity, as well as the timeframe. Binary options traders can adjust the period of the indicator, which will have a larger or shorter lag and will be placed closer or farther from the current prices. The percentage of the shift range will influence the width of the channel. For example, during high volatility, it’s worth enlarging the range width by increasing the percentage of the shift. On the other hand, when markets are quiet, squeezing the range of the channel by lowering the shift would lead to more accurate support and resistance levels.

How to read the moving average envelope?


The moving average envelope means how far the current price is from the volume-weighted average value. At the same time, envelopes show current trading conditions in terms of a strong trend. If, for instance, an asset price was above the simple moving average but below the upper line of the envelope, then the technical analysis would point to the bullish channel in play. Otherwise, the bearish continuation would be more likely.

Another important signal to monitor is the moment when prices cross the middle line of the envelope indicator from above or below. This means a shift in the technical sentiment and a possible change of the trend’s direction. Upside and downside lines of the indicator reflect resistance and support curves and bounce off them would indicate that the recent trend is exhausted and a reversal is possible. Breakout signals occur when the price closes the period above or below the borders of the channel. Strong trends could have a powerful price action outside the channel and this usually means the continuation of the rally.

Calculation


The moving average envelope formula is simple and it reflects the same mathematical approach as per simple moving average. So all of the close prices in the previous period have to be added and divided by the number of periods. The upper and the lower values multiple or divide the mainline value by the chosen percentage and added to or subtracted from the middle mean.

The calculations for envelope are:

Upper Bound = SMA50 + SMA50 * 0.05
Lower Bound = SMA50 - SMA50 * 0.05
Midpoint = SMA50

Where:

SMA50 = 50-day Simple Moving Average

How to use the moving average envelope indicator in binary options trading?


The MA envelopes are used to determine the trend’s direction and measure its strength, find reversal and breakout signals, as well as calculate possible support and resistance levels. The most effective application of the envelope indicator is to buy call options when the price breaks through the middle line from below and put options with a mirrored scenario. Another useful signal comes in when the rate is bouncing off the borders of the channel. It could be used to stop the trading cycle at the best moment to maximize profits. At the same time, reversal signals might show periods when an opposite trend might begin.

Since envelope indicators have a disadvantage of lagging signals, an additional technical instrument might help traders to increase the efficiency of a trading system and lower the number of false breakout signals. Envelopes usually work fine with fast and sensitive oscillators such as stochastic RSI or Williams %R. For example, if the price breaks through the upper channel but Stochastic RSI performs the bearish reversal in overbought territory, then a bearish reversal is more likely than a bullish continuation. Thus, traders should start buying put options if the next candles configure the reversal signal.

Another effective system is a combination of envelopes and trend indicators such as MACD. In this case, the middle line of the envelope is a threshold for a bullish or bearish acceleration in case if the MACD trend indicator has an appropriate pattern. Such a combination helps to highlight the strengths of both technical instruments and smooth their weaknesses related to the lagging nature of mathematical formulas.

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Examples of profitable trades


MA envelope and Stochastic RSI

The daily chart below shows how MA envelopes interact with Stochastic RSI oscillator. The first example shows that after the EUR/USD currency pair tested the upper band of the channel, but failed to breach it with the close rate, Stochastic RSI performed the bearish crossover and went off the overbought zone. That pattern confirmed the reversal signal and put options were in demand since then. Another example has a mirrored formation as the exchange rate did not cross the downside curve, bouncing off the support level, while Stochastic RSI showed a signal to start buying call options. In both cases, trading cycles were profitable.

Moving Average Envelope

MA envelopes and MACD

The chart below uses the same setup but with MACD indicator as to the secondary tool. Although MACD does not show reversals, its signals are useful in terms of finding moments when the technical sentiment has changed. As the example shows, EUR/USD breaks through the middle line of the MA envelope after MACD has a crossover or its histogram changes the colour.

Moving Average Envelope

Conclusion


The moving average envelope is a flexible and multi-purpose technical indicator to determine the trend’s direction, show reversal and breakout signals, as well as highlight support and resistance levels. Adoptive settings allow the indicator to be applied to any type of trading strategies on any asset and timeframe. However, the lagging nature of the mathematical formula might require an additional technical instrument to confirm or deny trading signals and improve the overall efficiency of the trading algorithm. Sensitive oscillators and powerful trend indicators might help traders to increase the accuracy of trading signals and improve the profitability of the trading strategy.


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