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Hunting Key Levels with the Envelopes Indicator

Reading time: 12 minutes

Envelopes.jpg

The Envelopes indicator is a tool that attempts to identify the upper and lower bands of a trading range. It does this by plotting two moving average envelopes on a price chart, one shifted up a certain distance above and one shifted below.

If the market price breaks through these bands, we may assign some significance to the move and trade accordingly. We'll talk in detail about this later on in the article, but let's first look at how we calculate the levels of these trading envelopes.

Calculating the Level of the Trade Envelopes

As we said in the preamble, the indicator works by placing trading bands above and below the price level of our instrument of choice. The basic methodology is to first take a moving average (MA) of the price. Often, this is a Simple Moving Average (SMA). We create our upper envelope by shifting this SMA a certain distance above the price. Similarly, we create our lower envelope by shifting the SMA the same distance below the price.

The precise calculation method is given by the two equations below:

  1. upper envelope = SMANx X [1 + D%]
  2. lower envelope = SMANx X [1 - D%]

Where is the price, N is the number of periods used for the averaging, and D is a deviation value. So if we chose 0.5 for our deviation value, the upper envelope would be 1.005 times the SMA (that is SMA x [1+0.5/100]).

Using the Envelopes Indicator in MetaTrader 4

You will find the Envelopes in MT4 as one of the standard indicators that come as part of the core tools embedded with the platform when you download it. These standard indicators are divided up into four basic types, which are Trend, Oscillators, Bill Williams, and Volumes. The Envelopes in MT4 is classified as being a trend indicator. You will therefore find it in the Trend folder in MT4's Navigator, as you can see from the screenshot below:

GBPUSD-Envelopes.png

Image source: MetaTrader 4 platform, 18 September 2017

Period is the window over which we average our values to construct our moving average lines. The default value is 200. Normally, I suggest beginning with default values when first starting to use an indicator, but this is a very long period and you may find a smaller value is more usable. The default value of 200 gives a very smooth curve that may lie substantially away from the current price and will be more suited to those looking to trade very infrequently.

The Shift field, which has a default value of 0, moves the average backward or forward along the x-axis (i.e., the time axis). A value of 10 moves the MA lines forward 10 bars, while a value of -10 would move them back 10 bars, and so on.

MA method defines the method used for averaging the values over the timeframe you have chosen with Period. The default value is Simple, which treats each price value with an equal weighting. You can choose from a variety of averaging methods, with Exponential, Smoothed and Linear Weighted being the other options available. Exponential is probably the most common of these alternatives, which assigns a greater weighting to more recent price values. The amount of weighting decreasing exponentially for each successively older price in the series.

Apply to defines which type of price value is used for each bar. The default value is Close, but there are many other options, including high, low, open, or median.

Deviation sets how much the moving average lines are shifted up and down on the y-axis (that is, the price axis). In other words, deviation is the key parameter that sets how wide or narrow the envelopes will be. The value is specified as a percentage. The default value is 0.5, meaning the moving average will be shifted up and down 0.5% in value.

In the image below, I have added the Envelopes indicator, using 20-period SMAs of the closing price to an hourly GBP/USD chart:

GBPUSDH1-Envelopes.png

Image source: MetaTrader 4 platform, price data from Admiral Markets, hourly GBP/USD chart, 11 September 2017 to 18 September 2017

I kept the Shift as 0 and used a Deviation value of 0.25%. The upper envelope appears as a dark-blue, dotted line and the lower envelope as a red, dotted line. Notice how we get a big breakout above the upper envelope in the middle of the chart and how this marks the start of a big upward slope in the price.

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Envelope Trading Strategy

As we have discussed, at the heart of the Envelopes indicator is a moving average. Inherent aspects of a moving average are consequently reflected in the Envelopes indicator.

So what do we know about a moving average?

A moving average is used as a trend-confirming tool; it also has uses as a trend-following tool; finally, it is a lagging indicator. All three of these aspects also apply to the Envelopes indicator. Let's discuss each of them.

Trend confirmation

A moving average smooths out price fluctuations and allows us to see the broader pattern of the market. A moving average that slopes upward confirms that prices have been trending upwards. Conversely, if a MA line slopes downward, it indicates a downtrend. With our Envelopes indicator, we can also look at the direction of our bands to inform us about the trend. If our bands are sloping upward, then it confirms an uptrend. If our bands are sloping downward, it confirms a downtrend.

Trend following

As a simple trend-following signal, we can look for those times when the current price crosses above a moving average line. This may be a signal for a breakout into a new upward trend. Likewise, a downward crossover of the price through the moving average may signal a new downtrend. We can use the Envelopes indicator in a similar manner. With our Envelopes, they show MA lines that have been shifted up and down. Therefore to cross through these lines, the breakout must be even more severe than when the price crosses a conventional moving average.

When the price breaks above the upper envelope, it is a signal that we may be seeing the start of a new uptrend. When the price breaks below the lower envelope, it is a signal that we may be seeing the start of a new downtrend. You should be aware that these signals come with a firm caveat: the majority of price breakouts do not go on to form new trends. They will instead more frequently revert back into the previous price range. When a new trend does form, however, price moves may be dramatic.

The duration and extent of the price move can substantially outweigh the losses incurred from those occasions when a trend failed to form. This, in a nutshell, is why trend following can be a stern test of discipline and nerves.

A lagging indicator

The third aspect we mentioned was that moving averages are inherently a lagging indicator. This is because the price data always incorporates periods of the past, so that inflexions in the market's direction will always be reflected more slowly by a moving average than by the price itself.

This takes us back to our first point about confirming a trend. If we enter an uptrend, you'll naturally see the price of the market moving upward. This will happen before you start to see a moving average turn upward. However, you can't really have any confidence that you're seeing an uptrend until you see the moving average also move up.

Likewise with our Envelopes indicator, the slopes of our bands will change after a market shift has occurred. How much more slowly this happens is a function of the size of the period — which is a double-edged sword. Envelopes with a large value for the Period parameter in MT4 will turn like a tanker. The lag is much greater than with a shorter, more responsive MA, but in turn they show a clearer picture of the market in which you can have greater confidence. Envelopes with a smaller value for Period will be more swift in response, but, in turn, are less smooth and therefore may be 'faked out' more easily by smaller market fluctuations.

There is no firm answer as to which value is best, and you may find that using a combination of more than one set of envelopes (say, one with a longer period and one with a shorter period) may paint a fuller picture. Really the best way to establish what works with your own methodology is to go ahead and try it out. A sensible way to do this is in a risk-free environment, where you can experiment as much as you want without any cost. This is why a Demo Trading Account is so useful. It allows you to trade on live market prices, but without taking on any risk while you are determining what works.

Turning Points in Market Price

Now, let's go back to our second point, which was the trend-following aspect. There are two ways of looking at the same indicator. To reiterate, we said a breakout may result in an enduring trend, but more frequently we will see the trend break down and prices will revert to a previous range.

A trend-follower may look at that information and see an opportunity to occasionally make a large profit with the encumbrance of frequent smaller losses. A counter-trend trader may be interested in the other side of the coin. Such a trader may see the opportunity to make frequent smaller profits, albeit with the risk of an occasionally large loss. Such a strategy clearly relies on keen risk management, as the long-term success will entirely depend on the ability to dodge the bullet of being the wrong side of a big trend.

So let's take it to an extreme and look at using the Envelopes indicator as part of a scalping system. Such a system might use Envelopes to pick key price levels, then an oscillator to confirm that the market is acceptably oversold or overbought. On the chart below, I have added the Envelopes indicator and the Williams Percent Range to a 5-minute GBP/USD chart:

GBPUSDM5-envelopes-scalp.png

Image source: MetaTrader 4 platform, price data from Admiral Markets, 5-minute GBP/USD chart, 10 August 2017

The settings I used for the Envelopes were a period of 50, a deviation of 0.15% with a method type of EMA applied to the close. I have also added a regular EMA with a period of 50, which is the green, dotted line that lies in the middle of the envelopes. I set the Williams %R to a period of 50 also.

The rules for this system would be:

  1. enter a long if the price breaks (that is closes) below the lower envelope and %R shows oversold;
  2. enter a short if the price breaks above (that is closes) above the upper envelope and %R shows overbought.

The first vertical, orange line on the chart indicates where we have the correct conditions to enter a long position. The price has closed below the lower envelope and %R is in oversold territory.

The first target level would be if the price crosses back above the central green line (indicated by the second vertical, orange line). A secondary target level would be if the price reaches the upper envelope (shown by the third vertical, orange line). You'd want to use a reasonably tight stop loss — since the deviation value is 0.15%, a stop loss of the same proportional size would be sensible. This would be roughly 20 pips in this circumstance.

The system described above is just an example, of course. To really fine-tune what you are doing, you should thoroughly backtest your strategies. A good way to do this is with the Trading Simulator which comes as part of MetaTrader 4 Supreme Edition. MT4SE is available as a free download and offers a more extensive choice of indicators than you will find in the standard version of MT4.

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Envelopes Indicator: Conclusion

Remember, building a complete Forex Envelope profit system is not just about signals telling you when to buy and sell. Obviously any trading system needs to tell you advantageous times to enter the market, but that's only part of the story. To trade successfully, you will also need to employ solid risk management, firm discipline, and have a systematic process for exiting both winning and losing trades.

We hope you have found this introduction to the Envelopes Indicator to be useful. You might also enjoy reading our article on Keltner Channels, which is another indicator that uses trading envelopes.

Risk Warning

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 83% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.