The moving average envelope, MAE for short, is a tool used to confirm trends. A moving average is built into this indicator.
Moving averages are a very common trading indicator used by traders globally. It “smoothens” price and “predicts” the market’s direction. Ideally, when the price of a currency pair is beneath a moving average, it is a sell signal. On the contrary, when the price is above a moving average, it is a buy signal.
However, in ranging markets, the moving average crosses price way too often. This action produces a lot of false signals. A good way to tackle this issue is by using the envelope indicator.
What Does The Moving Average Envelope Do?
A moving average envelope indicator has a moving average embedded in between two lines. The upper envelope lies above the moving average while the lower envelope lies beneath the moving average.
The main use of the envelope indicator is to give extra confirmation to moving averages. The moving average crossing price is not sufficient for trading decisions.
Hence, the price has closed above the upper or below the lower bands for more validation.
Overbought and oversold conditions imply a possible market reversal. Additionally, they can be a sign to close positions by taking profits/ cutting losses.
How To Calculate The Moving Average Envelope
The calculation for the moving average envelope depends on the type of moving average used. Broadly speaking, there are two types of moving averages.
The simple and exponential moving average. Unlike the simple moving average, an exponential moving average gives more important recent data.
So, it responds faster compared to the simple moving average. But, this also means you will be vulnerable to fake-outs due to the high sensitivity.
Regardless of the moving average being used, set the value of the time period desired. Then, the percentage value for the envelopes is set.
For instance, a 20-period moving average with a 2% envelope would be plotted as follows:
The upper envelope is plotted with this expansion:
20-day SMA + (20-day SMA x .02).
Differently, the lower envelope is calculated similarly with a small variation:
20-day SMA – (20-day SMA x .02).
How To Trade With The Moving Average Envelope Indicator
The moving average envelope is traded just like a regular moving average. The only difference is, after the cross, the envelope is used to verify the trend.
A less common way to trade with this tool is by taking signals based on overbought and oversold conditions.
Using The Envelope To Confirm Trends
Again, a moving average is in between the two envelopes So, it is an indicator that follows the market trend.
As a rule of thumb, when the price closes above the upper band, it is a buy signal. Contrarily, when the price closes below the lower band it is a sell signal.
In the image above, the price closed underneath the moving average indicating a sell signal. For further confluence, it is necessary for a close beneath the lower envelope.
Using The Envelope To Determine Overbought and Oversold Conditions
The upper and lower envelopes may act as dynamic support and resistance levels. The same rules that govern regular support and resistance levels apply here.
They are called dynamic because they are not stagnant. When the price touches the upper envelope and reverses, the pair is overbought. This action usually hints at a sell signal.
Conversely, when the price rejects the lower band, the currency pair is oversold; buy signal.
However, it is important to realize that oversold and overbought conditions can remain intact when a trend is strong.
As seen above, the price rejects the lower band; oversold. Oversold conditions show that buy reversal may happen soon. Therefore, a buy order is taken here for that reason.
The envelopes moving upwards confirms an uptrend. Falling envelopes show that the market is in a downtrend.
Furthermore, a pair is overbought when the price fails to break the upper band. This action usually hints at a sell signal.
Conversely, when the price rejects the lower band, the currency pair is oversold; buy signal.
Moving averages are easily tweaked to suit every trader’s needs. Such alteration might be needed due to trading styles and the time frame in question.
In general, moving averages with small periods are extremely sensitive to price changes. Conversely moving average with a larger time span is less sensitive to price changes.
Therefore, care is to be taken to ensure the period of a moving average is not too small as it will tend to follow price too closely.
Summary: How To Use The Moving Average Envelope
A lot of traders have adopted the simple or exponential moving averages as their go-to tool.
The moving average envelope greatly improves trading results. Since entry rules are improved, false signals are avoided.
It verifies trends while giving information on overbought and oversold conditions. All these put together will put you a step closer to consistency in the forex market.
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