Envelopes are technical indicators plotted over price charts with upper and lower bounds, most commonly exemplified by moving average envelopes. These consist of two moving averages, delineating upper and lower price range levels.
Envelopes assist traders and investors in pinpointing extreme overbought and oversold conditions as well as trading ranges.
Key Takeaways
- Envelopes in technical analysis refer to trend lines plotted above and below the current price.
- The upper and lower bands of an envelope are typically created using a simple moving average and a predetermined distance above and below this average. However, they can also be devised using various other techniques.
- Traders often react to sell signals when the price hits or crosses the upper band and to buy signals when it reaches or breaches the lower band of an envelope channel.
How Envelopes Work
Traders can interpret envelopes in numerous ways, with the consensus being their utility in defining trading ranges. When a price touches the upper bound, the security is viewed as overbought, prompting a sell signal. Conversely, a price hitting the lower bound suggests the security is oversold, triggering a buy signal—these strategies align with mean reversion principles.
Typically, the upper and lower limits are set so the price remains within these thresholds under normal conditions. For volatile securities, traders might use higher percentages to draft the envelope, evading whipsaw trading signals. Contrarywise, less volatile securities demand lower percentages to create an adequate number of trading signals.
Envelopes often accompany other technical analysis tools to bolster success rates. For instance, traders may spot potential opportunities when a price ventures outside the envelope, subsequently examining chart patterns or volume metrics to predict imminent tipping points. It’s crucial to note that securities can sustain overbought or oversold conditions for extended periods.
Example of an Envelope
Moving average envelopes stand as the most prevalent type of envelope indicator. Using either a simple or exponential moving average, an envelope emerges by specifying a fixed percentage to establish upper and lower bounds.
Consider a five percent simple moving average envelope for the S&P 500 SPDR (SPY):
Image by Investing Guide © 2023
Calculations for this Envelope:
Upper Bound = SMA 50 + SMA 50 * 0.05
Lower Bound = SMA 50 − SMA 50 * 0.05
Midpoint = SMA 50
where:
SMA 50 = 50-day Simple Moving Average
Traders might adopt a short position in the exchange-traded fund when the price transcends the upper range and take a long position when dipping below the lower range. In these cases, they would benefit from mean reversion over ensuing periods.
To manage risk, traders may set stop-loss points at a fixed distance beyond the bounds, while take-profit points are often aligned with the midpoint line.
