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Moving Average Envelopes consist of a moving average plus and minus a certain user defined percentage deviation. Moving Average Envelopes claim to be an indicator of overbought or oversold conditions, visual representations of price trend, and an indicator of price breakouts. The inputs of the Moving Average Envelopes indicator is shared below:
- Moving Average: A simple moving average of both the highs and the lows. (generally 20-period, but varies among technical analysts; also, a person could use only the close when calculating the moving average, rather than two)
- Upper Band: The moving average of the highs plus a user defined percentage increase (usually between 1 & 10%).
- Lower Band: The moving average of the lows minus a user defined percentage (again, usually between 1 & 10%).
A chart of the Nasdaq 100 ETF (QQQQ) shows a 20-day moving average with both a 1% and 2% percentage bands:
Interpreting the Moving Average Envelopes
In the chart above of the QQQQ's, the price is not trending. During non-trending phases of markets, it could be argued that Moving Average Envelopes would make great overbought and oversold indicators.
- Using the concept of range trading, a trader might buy when the stock price penetrates the lower envelope and closes back inside the envelope.
- Likewise, a trader might sell when the stock price penetrates the upper envelope and then closes back down inside the envelope.
Price Breakout Indicator
When stock prices are done resting and consolidating, they breakout, in one direction or the other. Hence:
- A trader might view prices breaking above the upper envelope as a potential buy opportunity.
- And when prices break below the lower envelope, a trader might view that as a selling opportunity.
An illustration of an upward price breakout is shown above on the chart of the QQQQ's. On the right side, the QQQQ's gapped up above the 2% price band.
Price Trend Indicator
A new trend in price is usually indicated by a price breakout as outlined above with a continued price close above the upper band, for an upward price trend. A continued price close below the lower band might indicate a new downward price trend.
In the chart of the QQQQ's, after the price breakeout, the closing price continued to close above the upper band; this is a good example of how a price trend begins. Soon after, the price will fall back into the Moving Average Envelopes, but the Moving Average Envelopes will be heading in a positive direction – easily identifying the recent trend as up.
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