In this article, we will examine how to trade with the moving average envelopes. We will talk about what moving average envelopes are, how they are derived or calculated as well as how they can be used for trading (which is basically as a trend seeking indicator).
A moving average envelope is an indicator which is based on a simple or exponential moving average, and sets bands based on a set percentage deviation, thus creating envelopes. These envelopes can then be used in two forms.
a) The envelopes can be used to determine what the trend of the currency pair is when the market is trending.
b) In cases where the market is range-bound, the moving average envelope indicator can also be used to indicate when a currency pair is oversold or overbought, just the way a momentum oscillator would.
In a typical chart which displays the envelope indicator, we will see a chart of a currency pair with a particular moving average as its base (the middle band). The upper band is then set at a particular percentage above the moving average and the lower band is set at a particular percentage below the moving average. This is almost similar to the Bollinger band indicator where the middle band is represented by the 20-day simple moving average, with an upper and lower band on the corresponding sides of the SMA.
CALCULATING MOVING AVERAGE ENVELOPES
So how are moving average envelopes calculated? The following parameters are used to determine how envelopes are derived or calculated.
a) Moving Average Settings
A component of the envelope indicator is the moving average. However, the trader must determine what kind of moving average should be used in the indicator parameter settings. Commonly, the simple moving averages and the exponential moving averages are the two moving averages widely used in envelope trading. The trader therefore must decide on whether to use the simple moving averages or the exponential moving averages in a particular trade situation. When making a determination of whether to use simple or exponential moving averages in the calculation, it is pertinent to weigh the pros and cons of the two types of moving averages.
As a rule, exponential moving averages tend to give greater weight to recent prices while simple moving averages give greater weight to all prices (recent and historical) within the period chosen in the moving average. Exponential moving averages are thus better suited to currency pairs that are extremely volatile or when the trader has a short term view to the trade.
We must understand that the simple moving average and exponential moving average envelopes are not usually used on the same chart at the same time. You must use either one or the other depending on what terms of trade you want to use.
In summary, use a simple moving average in the envelope indicator when:
– The currency pair is not too volatile.
– A long term trade focus is in view.
Use an exponential moving average in the envelope indicator settings when:
– The currency pair is volatile (a volatility indicator may be of help in this regard).
– The trade is going to be for the short term.
b) Time Period Settings
Another component of the envelope indicator is the time period on which the moving averages are based. Recall that when reference is made to a moving average, we talk of 20SMA or 50 EMA. The numerical component is the time period, and the trader must also determine the best time period on which the moving averages will be based. In other words, how many days should be set in the moving average component of the envelope indicator? What time period should a trader set for his moving average?
Again this will depend on the length of time that the trader wants to hold the position for. A trader who simply wants to trade by getting in and out of the positions at the shortest possible time would be better off using smaller time periods in his moving average calculation. In contrast, a trader who has more of an investment mindset, aiming to ride out the short term storms in order to reap a big pay day months or years down the road, would be better off using a longer time period.
c) Percentage Deviation of Envelope Bands
How wide should the envelope bands be? It is a real tricky business when it comes to setting the percentage deviation of the envelopes from the moving average. In order to understand how wide the envelopes should be, it is better to appreciate it by looking at it in this context. Bollinger bands and price channels each have automatic offsets which make them able to adjust the deviation of their bands to respond to the volatility of the currency pair being traded. However, moving average envelopes do not have this function, making them a lot trickier to use in terms of setting the appropriate width for trading. Bollinger bands make use of standard deviation to set the deviation of their bands from the moving average. Price channels use the average true range (ATR) to perform the same function. Without a standard way of setting the channel widths when using envelopes, the trader would be forced to do this another way. One of the methods available is to use historical backtesting to determine what the best settings of the band deviations would be for the moving average envelope.
In this chart example, we have used 5% (light colour), 25% (purple colour) and 50% (red colour) deviations for the envelopes on the chart of the S&P500 index on each side of the price action. Now we watch to see which of the envelope’s bands were touched by the price action of the asset when a historical price movement was considered. We can see that the asset did not touch the 50% envelope band (red colour), showing us that the envelopes set with 50% deviation were too wide. The asset’s price action touched the 5% bands (light colour) on both sides, but did that too often showing that this setting was simply too tight. This sort of setting would provide false signals that would lead to a lot of fakeouts. The asset also touched the 25% envelope bands (purple colour), but did so with just the kind of regularity we were looking for. So in this example, the 25% envelope would have been the best setting for the moving average envelope width. The same process can be repeated for the currency pairs to be traded, always using historical price behavior to determine what width settings would suit the trade.
USING THE MOVING AVERAGE ENVELOPE INDICATOR TO TRADE
So now that we have demystified how to devise the correct indicator settings to use in the indicator, the next question is how do we use the moving average envelope indicator to trade currencies in the forex market?
a) TREND IDENTIFICATION
As identified earlier in this article, one of the ways that the moving average envelope indicator is deployed is in determining the start of a new trend. This is where the behaviour of the price action relative to the bands of the moving average envelope come in very handy. If the price of the currency pair breaks above the upper envelope, then this is considered to be a bullish breakout and the trader would then have to trade the asset according to the principles we have outlined in this blog on trading breakouts of price resistance. So even if there is a pullback, this pullback would be to the upper envelope that has just been broken and the currency pair is expected to bounce off this upper trend line and continue higher, as the upper band will no longer function as a resistance but as a support.
Conversely, if the price of the currency pair breaks below the lower band of the envelope indicator, then it means that a downside break has occurred. Even if there is a short term pullback in the nearest future, this will usually be rejected at the lower envelope band (now acting as a resistance) and the currency pair is then expected to keep heading lower from there.
For these two scenarios to occur, the assumption is that the currency pair is trending. So what happens if the currency pair is in a period of consolidation?
b) TRADE REVERSALS
When it comes to a currency pair whose movement is flat or in consolidation, then a whole new dynamic comes into play. This time, if the price action touches the moving average envelope’s upper band, then it is a signal that the currency pair is overbought and due for a downside correction.
If the price action of the currency pair starts to pierce the lower envelope, then it means that the asset is due for a rebound as it is presently oversold.
Using this information, the trader can then trade within the range of price movement by selling on the upper envelope and buying at the lower envelope band.
THE ENVELOPE INDICATOR ON MT4
If you open the MT4 application of Forex4you, you will clearly see the following:
a) The Envelope indicator is classified as an oscillator. So accessing it will demand that the trader clicks Insert –> Indicators –> Oscillators –> Envelope.
b) Under the parameters in the pop-up box that opens, we can see the settings that need to be adjusted for the moving average envelope indicator to work maximally. The key settings are the Period, MA method (simple or exponential) and the band deviation (in %).
So the trader must know when to use the simple or exponential moving average, what period to use, and the deviation of the bands (i.e. the width distance of the upper and lower envelope bands). It is only when the steps that we have described above for deriving the optimum settings for the indicator are followed that the trader can proceed to use the indicator for trading.
STEP-BY-STEP TUTORIAL ON TAKING A TRADE WITH THE MOVING AVERAGE ENVELOPE
Okay, so now we are going to demonstrate how to trade with the moving average envelope indicator, starting from how to derive the optimal settings for envelope width, moving average method to be used as well as the time period. We will then use these settings and apply them to the envelope indicator, pin the indicator to the chart and then look out for trades that can be taken on the basis of trend break, or trend reversal.
Open the chart of the asset you want to trade, and setup the envelope indicator by attaching it to the chart three times. Adjust the moving averages depending on whether the market is volatile, or if you want to trade for the short term or the long term. See above content for detailed explanations on how to do this.
Adjust the deviations of the three moving average envelopes, assigning three different values to each of them. Also adjust the colours in such a way that the three envelopes will have three different colours. In other words, envelope 1’s bands should carry the same colour, and envelope 2 and 3 should also be adjusted likewise. See the S&P500 chart to see how this should look like when you are done. This step is to decide which deviation will best suit the chart.
Look at the price action and decide on whether the chart is trending or range-bound. If the price action is range-bound, buy on the lower envelope and sell on the upper envelope when the market is oversold or overbought respectively. If the market is trending, trade as we have specified for trending markets, which is on the break of the corresponding envelope band.
Remember to pay attention to risk management to manage your risk on the trades.
In conclusion, we should note the following about using the moving average envelope indicator.
a) There are two uses of the moving average envelope indicator. The first is in determining the new trend of the currency pair, when the currency pair is trending. The second is in determining overbought or oversold market conditions with a view to trading market reversals, when the currency pair is consolidating.
b) The trick in using the moving average envelopes is in setting the appropriate parameters, and the best settings can be obtained by the methods we have described above.
c) At the end of the day, the rewards that accompany the trades are usually worth the effort.
The author’s views are entirely his or her own.