Envelopes
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Description
Envelopes are a type of trading band used to determine the upper and lower trading boundaries of a security. Envelopes are created by plotting two curves parallel to a central Moving Average. Provided an appropriate period (or term) has been chosen, the distance of the two curves (or bands) from the Moving Average is such that 90% of the price action is included between the upper and lower bands.
Terms are generally chosen to be multiples or fractions of trading cycles. For example, 52 weeks, 26 weeks, 13 weeks, etc. The bands are actually plotted out of phase with the price-line by half the term chosen. In other words, if you choose a term of 52 weeks, the bands will finish 26 weeks behind the last price charted. The chart, complete with bands, can be printed and you can extend the bands (extrapolate) by hand, to try and continue the trend.
Interpretation
Since Envelopes define the upper and lower boundaries of a security's normal trading range, movement towards the upper band can be interpreted as over-buying (paying more than the security is worth) and movement towards the lower band as over-selling. The reasoning behind this is that market excitement will often push prices to extremes, before stabilising to more realistic levels. Basically:
If the price moves above the upper band, this can be considered a sell signal (go short).
If the price moves below the lower band, this can be considered a buy signal (go long).
Advantages and Disadvantages
Though identifying periods when prices are at an extreme (and perhaps unsustainable) level is useful, note that Envelopes only indicate that prices are high or low on a relative basis. Buy and sell signals are, therefore, not necessarily given when prices penetrate the upper or lower bands. Securities will often shift between periods of high and low volatility. A security can become over-bought or over-sold for an extended period, so it is important that an appropriate term is chosen for the data.
Envelopes are particularly useful in a sideways market (that is, when there is no clear upward or downward trend in price activity). Identifying a period of low volatility can serve as an alert to monitor the price action of a security. Other technical indicators can then be used to help determine the direction of a potential breakout.
TIPS:
Penetration of either band signals an imminent correction. Prudence suggests waiting until the market has reversed back through the band before entering the trade. For secondary confirmation of the signal, you may wish to use oscillators such as the RSI and Stochastic.
If two Envelopes are used (one with a much longer term than the other), their convergence provides a particularly strong signal.
Compare Envelopes with Bollinger Bands.
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