Moving averages (MAs) are a popular trading tool. Unfortunately, however, they tend to give false signals when markets are turbulent. Applying an envelope to moving averages can help avoid some of these turbulent trades and protect traders from losses. Envelopes have been a favorite tool among technical analysts for many years, and incorporating their techniques into moving averages can be a useful combination.
What is an envelope?
Moving averages are one of the easiest tools to use. Simple moving averages are calculated by adding the prices over a specified period of time. For example, a 10-day simple moving average is calculated by summing the prices of the past 10 days and dividing the total by 10. This process is repeated the following day, using only the data from the most recent 10 days. The daily values are combined to calculate a moving average, which can then be graphed. This technique is used to smooth the data and identify underlying price trends.
The chart above is a chart displaying the envelopes of 20 periods of moving averages with a 0.05% divergence. The reversal can be seen when the divergence increases.
Drawbacks of Envelopes
Envelopes are designed not to display buy and sell signals until a trend is established. Traders thought that by using a price that is a few percent of the moving average as an entry point before making an entry, they would be able to prevent rapid trading that could easily result in losses. However, the drawback of using the envelope is that it delays entry on winning trades and returns more profit on losing trades.
From Envelopes to Bollinger Bands
The purpose of using moving averages and envelopes is to identify changes in trend. In many cases, the change in trend is large enough to offset losses from whipsaw trading, making it an effective trading tool for those who are willing to trade at low profit margins.
The first advocate of the countertrend strategy was Chester Keltner, who defined the idea of the Keltner band in his 1960 book “How to Make Money in Commodities,” in which he performed a slightly more complex calculation.
He used the average of the opening, high, low, and closing prices to find the moving average. Keltner also featured a 10-day simple moving average of the daily range (high minus low) as the width of the envelope, instead of drawing a fixed percentage envelope. Entry points occur when the band is touched as well as the envelope.
Later, John Bollinger developed the Bollinger Bands based on the ideas of the Envelope and Keltner Bands.