A trend indicator quite popular in the world of technical analysis but not so much among the Hispanic niche is that of the directional lines, known as Envelopes.
What are these Envelopes for trading?
Well the same name tells us more or less because it is to apply two moving averages on the price of the asset that will be making a kind of sandwich with the price because one average will go above and the other below.
Another very similar indicator is the Bollinger Bands that also consists of two bands that go above the price of the asset.
How to calculate the Envelope?
Well in this case it is quite simple because we will simply have to calculate the two lines:
- Top line = SMA (X) * [1 + k / 1000]
- Bottom line = SMA (X) * [1-k / 1000]
SMA: is the Simple Moving Average of a given period “x”
k / 1000: deviation from the average
How to trade with these Envelopes?
You can find more about this topic in the article that I wrote about Enveloping Channels, but I remember again the fundamental principle on which this type of trading is based.
Supposedly having two moving averages above and below the initial price would have a situation in which the market would tend to “tell us” that the price is overbought when it touches the top of the “envelope” or oversold when it touches the bottom.
That is in theory, and the truth is that if we think logically it is true that markets always tend to return to a kind of average, that is, after they move in a strong direction.
When these directions occur, the circumstance usually happens when we find something of value, since most of us are buying or selling.
As we should know when the mass is going to one side usually a phenomenon of imbalance occurs and then the thing is usually adjusted to bring the price to a medium term.
The latter applies to the stock markets where many of these cases occur, especially in long-term variations, hence the obsession of many to seek “value” when the price of the share has fallen more than expected, for example , when there is excess of sale for “fear”.
In the rest of the markets the same thing happens because all the markets, after all, move out of fear and hope.
Up to here it is clear.
However, the reality of trying to apply trading strategies based on this indicator is not so easy. In fact, it’s not easy at all.
If you look at any stock market chart, whether it be stocks, indexes, currencies, commodities, bonds or crypto currencies, you will see that there are many cases in which the price is reversed when it touches those higher or lower bands, but there are also many cases in which the price continues to rise or fall so that it seems that it will never return to the average.
In the end, the price always returns to the average, but there are times when before doing so you can lower 5, 10 or even more times the magnitude of the separation of the “Envelopes”, with what we can imagine the problems that we can have if we try to follow strategies of type: “sell in upper band” or “buy in lower band”.
In general, I comment:
Strategies like the one I just mentioned work well in lateral or semi-lateral markets.
In strongly bullish and, above all, bearish markets, they are horrible, because the price violates time and time again, one of the sides of the “envelope”.
Ideal period to apply the Envelopes
Here we have several possibilities, which become infinite later when applying the appropriate changes to the different variables.
How confusing is this to have infinite possibilities, no?
Yes, but calm that is for everyone and with all the indicators.
In this case we can apply temporalities based on the size of those moving averages, and also on the deviation we want to apply.
But that is not everything, because we can also use exponential moving averages.
In the case of the period of the moving average, the longer period the fewer number of times we will be able to see how the price touches those ends of the envelope, so only in markets of certain volatility or in which there is a very clear movement, we should expect these extremes to touch each other.
The latter is especially important depending on the asset that we are trading, since it is not the same an “envelope” for a cryptocurrency with a daily volatility of 8% that a pair of forex with the same data of 0.8%.
The results in both cases will vary dramatically.
Choose the K with the Envelopes
Therefore, the higher volatility we should look for a higher k.
This k is a separate issue because if we choose a low one we will have the price touch many times and if we choose a high one, we will have the opposite case.
That is, in the first case we will have countless potential operations and in the second only a few.
Day trading with envelopes
On the other hand, we will also have to take into account the period of the chart that we are going to negotiate, since it is not the same to be negotiating intraday sessions than longer sessions.
If we look at the 15-minute bar chart, we see that a deviation of 0.10% may be sufficient in the EURUSD, while in the case of daily bars this deviation is insignificant.
If you look at these short-term charts we also see many cases in which the price is reversed by touching the ends, but many others in which it continues moving by touching them.
You will have to be the one to apply the appropriate strategy to try to beat this market.
Strategy that can have infinite possibilities, going from the amount of benefits we collect, to the stop loss, to the choice of the k, of the simple or exponential moving average and its value, of the asset, of the period of time that we want to use to negotiate .
Depending on these variables we will have to apply some results or others, since a stop loss for the daily chart is not the same as another one for the 15-minute bar chart.
As you can see, just to study this indicator we already have enough possible parameters to put to study.
Surely you will not get bored.
I’ll give you a tip, about a possible beneficial operation with these Envelopes.
For example, in an important bull market of shares, such as in the DAX index, a broad Envelope, with a period of 30 days moving average and a deviation of between 2.5 and 3%, will give us good entries up when the price touches the bottom side.
Original article: Indicador Sobre para trading