Simple moving average can be transformed into a new tool - moving average envelopes. This tool, like the [[Bollinger bands|Bollinger bands]], is used for the detection of the current price movement boundaries.
The indicator consists of three lines.
The upper envelope band:
Moving Average Upper Band = Moving Average +(K/100) x Moving Average
where K is the percentage of the price to which the MA uprises.
The lower envelope band:
Moving Average Lower Band = Moving Average - (N/100) x Moving Average
where N is the percentage to which MA downfalls.
Moving Average Envelopes consist of two MAs (which can be referred to as simple, exponential or other), one of them is shifted upwards, another - downwards to a certain percentage (called the envelope’s coefficient).
Sometimes the third line is depicted, or the central MA, starting from which the shifting is made.
For example, the 2% envelope of MA will look like two bands - the first one is the MA, shifted upwards by 2%, the second one is shifted downwards by 2%. It is considered that the envelope determines the boundaries (the upper and the lower) of the currency pair normal price change. The principle of MA band use is as follows: after a few changes, the price always returns to its general trend (to its central moving average). It happens because the more the price differs from its tendency, the more traders fix profit by returning the price to its normal trend.
The bigger the volatility of the analyzed market is, the wider band limits should be chosen.
Use of MA envelopes.
There is a number of methods of MA envelopes usage.
After the accurate shift coefficient selection, the upper band is used as the level of resistance and the lower one as the level of support. The corresponding strategy for this is selling at the upper level and buying at the bottom.
The use of line breaks as the movement development indicator.
Sometimes Moving Average Envelopes are used as a filter, while exploiting the signals of price crossover by MA. Thus, the purchase, for example, is made, when the currency price at first has crossed its MA upwards, and then the upper band of the envelope. The sell is accomplished in the opposite situation: when the price has firstly crossed its MA downwards, and then the lower envelope band. Such strategy considerably decreases the number of false signals (since the trader does not enter the market in the outset, when the price is still in the envelope), but when the trend is real, the signal comes a bit later, and the trader loses part of the trend movement (equal to or more then the envelope’s coefficient). This strategy is well described in the book by Charles Le Beau, David W Lucas 'Technical Traders Guide to Computer Analysis of the Futures'. Like in the case with SMA parameters defining, the trader using the envelope, faces a dilemma, whether to get more false loss entries, or to skip the part of the trend. The first technique is mostly used for short-term trade, the second - for mid-term and long-term trade.
Drawbacks of Envelopes
Like every indicator, created on the basis of MA, the envelopes of MA lag behind. The MA envelopes are not able to fit into the current volatility of the market, like the Bollinger Bands, for example.
Go to InstaForexGo to Leave