Envelope - Envelopes
December 28, 2008
Definition:
The envelope study is a derivation of the moving average study. The parameters used to compute the study are:
• The period, the number of bars used to calculate the moving average, basis the close
• Percent, a percentage deviation from the moving average
Formula:
Top Band = * ((100+P)/100)
Bottom Band = MA * ((100-P)/100)
MA = Moving Average basis the close
P = percentage offset
Interpretation:
This indicator needs to be tuned to each individual market, beginning with a Moving Average that needs to be applied to smooth the volatility of the market. The percentage offset then needs to be ascertained so that the bands envelope the previous or recent trading activity. Half the average daily range or a little above is a good starting point, using a daily bar chart.
The theory is that when the market is stretched to an extreme price, relative to recent activity, it’s either trending or about to change direction. In general, the market spends most of the time not trending. It varies from market to market, but as a rule of thumb (basis a half hour chart) markets trend for only about 20% of the time. The rest of the time, about 80% of the time, is spent oscillating within a trading range.
If the market is trending, then it should be obvious or we can use another trend type indicator, like the ADX, to determine this state. If it\’s not trending then we can assume that as price approaches the top band it will attract sellers and as it approaches the bottom band it will be advertising to buyers. In simple terms we can say that there is a buying opportunity at the lower band and a selling opportunity at the higher band.
On the other hand, if it is determined that the market is trending or in a position to start a new trend, then price moving outside the envelope is actually a signal to go with the market.
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