Looking for newer and better, at least in theory, indicators of technical analysis you will eventually come across the Envelopes tool. This is one of the indicators belonging to a group of so-called bands –surely Bollinger bands have come to your mind. And that’s right. This is the same set of indicators, but of course, they differ from each other. Envelopes, because this is how the indicator is called (also referred to as Price Envelopes) are more of a niche, if the default tool available on the MetaTrader 4 trading platform can be described in this way, tool of technical analysis.
Indicators of the band type are very popular among investors trading in all markets, not only in the Forex market. They are very grateful tools. Some are more (Bollinger bands) and others less successful (Donchian channel), but they definitely deserve attention.
Construction and operation of Envelopes indicator
Price envelopes are made up of two moving averages, one of which runs around the price maxima of a particular financial instrument at a certain point in time, and the other around its minima. The moving averages define the highest and lowest range of fluctuations in the quotations of an instrument.
Typically, the Envelopes indicator is based on simple moving averages calculated from 20 periods. Some strategies use, however, exponential moving averages, sometimes also calculated for another time period. In addition to selecting the type of average and length of the period, you also need to set the p factor. This is the percentage deviation from the average price. P is usually 2.5, 5 or 10%. To the upper moving average the percentage p is added, and it is subtracted from the lower band. With such indicator settings, from 85% to 90% of price movements are within the band.
Upper envelope = SMA + p * SMA
Lower envelope = SMA – p * SMA
Use of Envelopes indicator
One of the tasks of the Envelopes tool is to signal the appearance of a trend – it is used by investors as a delayed indicator. In addition, in the case of a sideways trend, price envelopes may indicate to investors on what level the market is overbought and oversold.
Transactional signals generated by envelopes are pretty straightforward – as a rule, the artificially high or low prices tend to return to more fundamental levels. For this reason, the basic strategies using the Envelopes indicator assume that the buy signal is generated when the lower envelope is broken and the sell signal appears when the price of the instrument rises above the upper envelope – it is assumed that the price will return to the middle of the envelope.
With price envelopes, it is good to use other technical analysis indicators that would indicate a strong advantage for one of the parties. Why? Although in most cases the price stays between the envelopes, sometimes breaking one of them will be the beginning of a new trend or a signal to deepen the already dominant trend, and in that case taking the position in accordance with the strategy mentioned above will end in a loss. Other AT indicators in this case have the task of determining the probability of a stronger knockout – if it is large, it is better not to take a position in line with previous findings.
Advantages of Envelopes
- Possiblity to use at all intervals
- Possiblity to use at all markets
- Easily readable signals
- Easy contruction
Drawbacks of Envelopes
- Necessity to filter the signals