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 too often. This action produces a lot of false signals. An excellent 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 between two lines. The upper envelope lies above the moving average, while the lower envelope lies beneath the moving average.
The primary 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 is 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. An exponential moving average gives more important recent data than a simple moving average.
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 time value 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 slight 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.
READ MORE: Three Best Indicators For Swing Trading
Using The Envelope To Confirm Trends
Again, a moving average is between the two envelopes. So, it is an indicator that follows the market trend.
As a rule of thumb, it is a buy signal when the price closes above the upper band. Contrarily, it is a sell signal when the price closes below the lower band.
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.
READ MORE: Best Moving Average For The 15 Minutes Chart
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. The pair is overbought when the price touches the upper envelope and reverses. This action usually hints at a sell signal.
Conversely, when the price rejects the lower band, the currency pair is oversold, a buy signal.
However, it is essential 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.
READ MORE: A Guide To Understanding The Dow Theory
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, a 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.
Moving averages with small periods are extremely sensitive to price changes. Conversely, the moving average with a more significant period is less sensitive to price changes.
Therefore, care is to be taken to ensure the moving average period is not too small, as it will tend to follow prices too closely.
Summary: How To Use The Moving Average Envelope
Many traders have adopted simple or exponential moving averages as their go-to tool.
The moving average envelope significantly 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, together, will put you closer to consistency in the forex market.
Leave a Reply