Learn To Use Moving Average Envelopes

A moving average envelope (MAE) is a three line technical analysis tool that uses a moving average and an upper and lower band.

The upper and lower bands sit a certain percentage away from the moving average you are using.

The word envelope indicates that price should be surrounded by the upper and lower bands.  In this stock chart of Moderna (3% band, 20 EMA) you can see that is not the case.

We will cover why later in this piece.

What Does A Moving Average Envelope Tell You?

There are three main uses for the MAE:

• Confirmation of trend direction
• Upper band = showing overbought condition
• Lower band = showing oversold condition

Traders will then define trading rules around that information to enter, mange, and exit a trade.

The envelopes do not adjust to volatility like the Keltner Channel or Bollinger Bands do.

Moving Average Envelope Best Settings

The common question about any technical indicator is what the best setting is.

There is never a universal best setting and the default setting is often a starting point.

For the envelopes, the standard settings are:

• Exponential moving average setting of 20 (closing price)
• Bands multiplier set to 5%

Using an EMA for the average allows the indicator to weigh more heavily on recent price data.

While the default may be fine for some instruments, it won’t serve those where volatility is high.  The first price chart shows price heavily into overbought territory for 32 bars.

You will have to experiment with different settings and even time periods so that the bands have some interaction with the movement of price.

There are many combinations to try and I simply use the Fibonacci number series for a consistent way to test the settings.

You can see the 8% MAE with a 20 period EMA interacts better with the ebb and flow of Moderna except when we see the 90% run up in price after the gap up.

Moving Average Envelopes To Confirm Trend Direction

One of the biggest uses of any moving average is the trend direction ability and the MAE is no different.

Using the slope of the envelopes can give you an objective determination of trend.

• Envelopes sloping to the upside, we see an uptrend
• Sloping to the downside, you consider a downtrend
• Sideways movement of the envelope is a trading range

Traders may also use a break of the upper envelope or lower envelope for trend confirmation.  This, obviously, will depend on the percentage used.

• Too high of a percentage (wider envelopes) may never see either side get broken
• Too low of a percentage could see whipsaw

Again, it is up to each trader to determine their own settings based on the trading needs.

How To Trade With MAE

There is some that feel price breaking out of the envelope shows strong trend strength in that direction.

• Breakout through upper envelope is a buy
• Breakdown through the lower envelope is a sell

The percentage setting is vital to ensure you are not entering at the tail end of strong moves in price.

I set the bands to 5% of a 10 period EMA.  The arrows are showing breaks to the upside and you can agree this would be a painful way to trade during this period.

Can you adjust the settings?

Sure.

You can optimize anything using past data but it does not mean you will get any better results.

The issue is the inability to account for changes in volatility.  Using breakouts as a buy setup or sell setup depends a lot on what setting you will use.

Using Oversold Or Overbought

Let’s consider that instead of buying breaks of envelopes, we consider the bands as an oversold level or overbought level.

This is where we would look for a reversal of price.

Using a 20 period EMA and a 5% envelope, this stock does have some opportunities to short.  How you enter will depend on which type of entry trigger you use.

You can see on the right side, price remained oversold and gave almost zero traction to the upside.

Pierce And Pullback Strategy

We talked about the common ways to trade the envelopes but let’s look at one that may be of interest.

The “Pierce and Pullback Strategy” requires:

1. Price to break the high or low of the envelopes.
2. Look for price to pullback to around the moving average
3. Look for a setup in the previous direction
4. Manage trade upon return to envelope (profit taking?)
5. If price travels to opposite side of envelope, trade idea is cancelled

Let’s use the stock chart of Goldman Sachs.

You can see where price breached the envelope and that is your signal to look for price around the moving average.

There are various types of entry triggers here:  trend line breaks and breakouts.

All of these trades had positive price excursion.  All the longs came back to the upper envelope.

Left out of this is stop loss placement.  You can use average true range or above/below the candle that gets you into the trade.

Conclusion

The moving average envelope is static meaning it does not adjust by itself.

Traders will have to continually make adjustments depending on the instrument they are trading.

I much prefer a volatility based approach using Keltner Channels.  This way, the width of the bands will adjust to market conditions.

You can learn more about a Keltner Channel trading strategy here.