The Envelopes forex indicator is a technical tool that tries to spot the upper and lower bands of a trading range.
It does this by drawing two moving average envelopes on the activity chart, one lifted up a certain distance above and one shifted beneath.
The moving average envelope remains one of the most common example of an envelope and gets formed using two moving averages that define lower and upper price range areas.
Traders commonly use the envelopes to spot extreme overbought and oversold market conditions along with trading ranges.
Trading the Envelopes Indicator
Envelopes are interpreted in a lot of ways by traders, but a number of them use them to describe trading ranges.
When price test the upper boundary, price is said to be overbought, and a sell signal is triggered.
On the contrary, when price test the lower boundary, the asset is said to be oversold, and a buy alert is triggered. This rule is based on the mean reversion principles.
As seen on Fig. 1.0, the upper and lower boundaries are naturally defined in a manner in which price tends to remain within the upper and lower limits during standard conditions.
When dealing with a volatile asset, investors could use higher deviation percentages when using the envelope in a bid to avoid whipsaw trading alerts.
In the meantime, less volatile assets may require lower deviation percentages in order to create the required number of trading alerts.
Fig. 1.0
Envelopes are frequently deployed in combination with other forms of technical analysis to improve the likelihood of success.
For instance, traders may spot possible openings when price spikes outside the boundaries of the envelope, upon looking at volume metrics and price action patterns to spot a possible reversal point.
This is true since financial assets do end up trading along overbought or oversold conditions for a sustained period of time.
The calculations for the upper and lower line of the Envelopes forex indicator is simple and straightforward.
Upper Band = SMA(Close, N)*[1+K/1000]
Lower Band = SMA(Close, N)*[1-K/1000]
Where:
SMA — Simple Moving Average;
N — averaging period;
K/1000 — the value of shifting from the average (measured in basis points).
The main aim of using envelopes indicator is to spot changes in trend.
Most times we encounter trends that are huge enough to offset the losses suffered by whipsaw positions, which suggest this as a veritable tool for traders willing to accept a minimal percentage of winning trades.
Chartists are required to independently account for volatility when modifying the setting of the Moving Average Envelopes.
Enough considerations should be given to assets with low or high volatility, as they will require narrower or wider bands in that order in order to encompass their respective price action.
Understanding Basic Envelopes Signals
The Envelopes trading indicator is built on the moving average, and one should expect intrinsic features of a moving average to get reflected within the Envelopes indicator.
Moving averages are common tools used in confirming trends, and can also serve as a trend-following technical tool.
The lagging attributes of the moving average also adds up to the prior two attributes in fashioning the Envelopes indicator.
1. Trend Study
In order to see the bigger market pattern, a moving average tool is used in smoothing out price fluctuations.
If a moving average slopes upward, it is a confirmation of a bullish market trend.
On the other hand, if a moving average line slopes downward, it is a confirmation of a bearish trend.
This implies with the Envelopes indicator, one is able to also look at the direction of our bands to get vital information about the trend.
If the bands of the Envelopes indicator slopes upward, then price is said to be bullish, if the bands of the Envelopes slopes downward, it is a confirmation of a bearish trend.
A CCI indicator can be combined with an Envelopes indicator to improve profitability.
When trying to spot strong market moves that signals the beginning of an extended trend, an Envelopes indicator comes handy.
When the bigger trend is down, overbought readings can be deployed in spotting pullbacks to enhance risk-reward profit for a position.
Momentum turns bearish again when the CCI indicator pushes into negative territory.
On the part of the Envelopes indicator, if price breaks above the upper envelope, it is a trigger signaling a likely start of a new trend.
If price on the other hand dips below the lower envelope, it is a trigger signaling a start of a new downtrend.
Care must be taken when we experience such breakouts, because majority of them do not necessarily form new trends.
In most cases we see them reverting back to their prior price range. Price action may become dramatic when a new trend gets in the making.
2. Overbought/Oversold
The Envelopes indicator can be used to determine overbought/oversold market conditions.
Although assets can become overbought/oversold and stay overbought/oversold during a strong uptrend/downtrend respectively.
In order to pull this tricky feat off, watch out for when price will go above the upper envelope and stay above this line as an indication of a strong uptrend.
In actual fact, the upper envelope is seen to surge following the continuous price jump above the upper envelope.
This may seem overbought in theory, but it is signaling that overbought conditions will be sustained.
The same is true for oversold conditions.
Fig. 1.1
The EURUSD starts off in the overbought territory when it broke above the blue upper band of the envelopes indicator and looking at the CCI as well, we see the indicator telling us that price is overbought as well.
We got a pullback trigger from the CCI as its line breaks below the 100 to confirm a sell signal (see Fig 1.1).
The second scenario depicts price breaking below the red lower boundary of the envelope indicator (which shows an oversold market conditions).
Meanwhile, the CCI confirms the oversold market condition when its line stays below the -100, and a break above the -100 confirms our pullback i.e. a trigger to go long on the EURUSD pair.
Envelopes trading strategies for scalpers
Scalping with the envelopes indicator is possible when using the 1-minute, 5-minute and maybe 15-minute charts.
Set the envelopes indicator to (period 40, deviation 0.1) and apply the indicator on one of the above mentioned chart timeframe.
We would advise trading breakout on the upper and lower boundaries.
If price closes outside the upper or lower boundary while the previous candle close within the boundaries, this is bearish or bullish trigger respectively.
Checkout an envelopes trading strategy for scalpers here to heighten your understanding on the subject.
Envelopes trading strategies for day traders
Day trading on the envelope indicator can be tricky, however modifying your settings can be of enormous help.
Ensure that you stick to higher timeframes i.e. the 1-hour, 4-hour and 1-day charts.
Set the envelopes indicator to (period 28, deviation 0.75) and add the Williams’ Percent Range to your chart for trade confirmation.
Trading the breakout technique is relevant and applicable when day trading.
The trick is to watch out for price to break above the upper boundary of the envelopes indicator to satisfy for an overbought condition.
If the Williams’ Percent Range becomes gets overbought (aqua line sits above the -20.00) and later falls below this level, a sell trigger is said to be triggered.
Conversely, if price breaks below the lower boundary of the envelopes indicator, an oversold conditions is in the making.
Wait for the %R to break above the oversold region (-80.00 level) to trigger a buy alert.
See our example on how the envelopes indicator can be deployed when day trading here.
Envelopes trading strategies for swing traders
Swing trading is possible when using the Envelopes indicator and gets even better when it’s combines with other technical indicators i.e. the Stochastic to help in spotting overbought or oversold bounce.
Set the envelopes indicator to (period 10, deviation 0.75) and the Stochastics indicator period to 14.
Trade the overbought/oversold trading strategy on the 4-hour timeframe.
Also peruse some of our swing trading strategies deployed for swing traders here.
Conclusion
The envelopes is frequently used as a trend following indicator, but does also serve as an overbought/oversold spotting tool.
Following a consolidation period, a strong envelope break can trigger the beginning of a protracted trend.
Once a trader spots an uptrend, technical analysts can decide on using momentum indicators along with other systems to pinpoint oversold area and pullbacks held within such trends.
Overbought market conditions along with bounces can be deployed as selling openings within a bigger bearish market condition.
If a strong trend is absent, the envelopes can function like the Williams’ Percent Range oscillator.
Price actions above the upper boundary of the envelopes indicator signals overbought conditions, while price actions below the lower envelope signals oversold conditions.
It is crucial to imbibe other technical analysis types in order to confirm overbought and oversold price levels.