What is a Moving Average Envelope?

Moving averages (MA) are a popular trading tool. Unfortunately, they are prone to giving false signals in choppy markets. By applying an envelope to the moving average, some of these sawtooth trades can be avoided and traders can increase their profits. Envelope trading has been a favorite tool of technical analysts for years, and integrating this technique with AMs is a useful combination.

Understanding Moving Average Envelopes

Moving averages are among the easiest to use tools available to market technicians. A simple moving average is calculated by adding together the closing prices of a stock over a specified number of periods, usually days or weeks.

For example, a 10-day simple moving average is calculated by adding the closing prices for the last 10 days and dividing the total by 10. The process is repeated the next day, using only the last 10 days of data. The daily values ​​are put together to create a data series, which can be graphed on a price chart. This technique is used to smooth the data and identify the underlying price trend.

Simple buy signals occur when prices close above the moving average; sell signals occur when prices fall below the moving average. This idea is illustrated using a historical example of Starbucks (NASDAQ:SBUX) stock from 2007. The chart below indicates that the large arrows show winning trades, while the small arrows show losing trades when transaction costs are taken into account.

Disadvantages of envelopes

The problem with relying on moving averages to define trading signals is easy to spot in the chart above. While the winning trade shown in this chart was very large, five trades resulted in small gains or losses over a five-year period. It is unlikely that many traders will have the discipline to stick with the system to take advantage of big winners.

To limit the number of sawtooth trades, some technicians have proposed adding a filter to the moving average. They added lines that were a certain amount above and below the moving average to form envelopes. Trades would only be taken when prices passed through these filter lines, called envelopes because they enveloped the original moving average line. The strategy of placing the lines 5% above and below the moving average to form an envelope is shown below.

In theory, moving average envelopes work by not showing the buy or sell signal until the trend is established. Analysts felt that requiring a close of 5% above the moving average before going long should prevent fast, see-saw trades that are prone to loss. In practice, what they did was raise the jigsaw line; it turned out that there were just as many fake moves, but they happened at different price points.

Another disadvantage of using envelopes in this way is that it delays entry on winning trades and returns more profit on losing trades.

Improve how envelopes work

The purpose of using moving averages or moving average envelopes is to identify trend changes. Often, the trends are large enough to offset the losses incurred from swing trades, making them a useful trading tool for those willing to accept a small percentage of profitable trades.

However, savvy market observers have noticed another use for envelopes. In the chart below we show a weekly chart of Starbucks with a 20 week moving average and envelopes set at 20% above and below the moving average. Most of the time, when the prices touch the envelope lines, the prices reverse. But there are times when they continue to trend, resulting in losses.

Among the early proponents of this counter-trend strategy was Chester Keltner. In his 1960 book, How to make money in commoditieshe defined the idea of ​​Keltner bands and used somewhat more complex calculations.

Instead of using the close to find his moving average, he used the typical price, which is defined as the average of the high, low, and close. Instead of drawing fixed percentage envelopes, Keltner varied the width of the envelope by setting it to a simple 10-day moving average of the daily range (which is the high minus the low). This method is illustrated below.

Buy signals are generated when prices touch the lower band, represented by the green line in the chart above. Although Keltner bands are an improvement over the defined percentage moving average envelope, significant losses are still possible. As can be seen on the right side of the chart, the last time prices touched the lower envelope of this chart, they continued to decline. A simple stop-loss would prevent losses from becoming too large and would make Keltner bands, or a simpler moving average envelope, a tradable system with profit potential for traders across all timeframes.

Later, John Bollinger built on the idea of ​​moving average envelopes and Keltner Bands to develop Bollinger Bands®, which enveloped a simple moving average with lines two standard deviations above and below of the moving average. This is a mathematically accurate way to implement envelopes to achieve a high number of winning trades, as Bollinger Bands® are designed to contain 95% of the price action.

The essential

Moving average envelopes offer a useful tool for spotting trends after they have developed. More precise tools based on the same idea, such as Keltner Bands or Bollinger Bands®, are useful for identifying high-probability reversal points in short-term trends. All traders can benefit from experimenting with these technological tools.

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