The envelopes indicator is a rather unique trading indicator. Unlike most trend following indicators such as moving averages, the envelopes indicator follows the mean reversion concept.
The mean reversion is based on the principle that prices tend to revert to the mean when they deviate too far away. As such, the envelopes indicator provides traders a different way to trade the underlying markets.
The envelopes indicator is comprised of 3 bands, namely a moving average and an upper and lower band. The outer bands are placed at a fixed percentage away from the moving average.
How are Envelopes Indicator Calculated
The envelopes indicator comprises of a band and a mean.
The mean is usually an exponential moving average for a period that the trader can specify, while the upper and lower bands are a fixed percentage from the mean price.
Therefore, an envelopes setting of 50, 1 infers that the indicator will plot a 50 period moving average with an upper band 1% from the mean and the lower band 1% away from the mean.
In regards to calculating the envelopes bands, the formula for the bands are:
Upper band = (1+ deviation/100) x Moving average
Lower band = (1- deviation/100) x Moving average
Below is an example chart with a 20 period and 2% deviation envelopes settings.
Trading the Envelopes Indicator
Trading the envelopes indicator is very simple and directed by the mean reversion. When price touches the upper band, it is considered that the price has deviated too far from the mean.
Therefore a sell signal is triggered with short positions while the target is at the moving average reading. Likewise, a buy signal is triggered when price touches the lower band with the target set to the moving average of the mean.
Despite its simplicity, trading a simple buy or sell when price comes close to either of the upper or lower bands does not always give profitable trades.
Because of the fact that the deviation from the mean is fixed, during times of volatility, prices can break one of the bands and continue on in their extreme trends. In the chart below we illustrate this point.
Notice how price reached the upper band but continued to push higher for 8 straight candles before moving back to the moving average line. A simple sell when the first candle touched the upper band would have resulted in a -ve equity for the period of time.
Envelopes & Bollinger Bands
An important distinction to make here is that envelopes should not be misunderstood as a measure of volatility, which is what Bollinger Bands does.
Rather, the envelopes indicator only points out how far price has deviated away from its moving average price. The difference is also visually seen. While Bollinger Bands © tends to expand and contract based on current market dynamics, the envelopes indicator remains fixed through out.
The chart below compares the same period of time using the envelopes indicator and the Bollinger Bands to illustrate this difference.
Envelopes Trading Strategies
The envelopes indicator is one of the most simplest of indicators that follows the reversion to the mean concept of trading. While it might look simple to buy or sell at extremes, most often price tends to pus through the extremes.
And because envelopes make use of a fixed percentage deviation from the moving average line, they are not the best of indicators to use during market volatility and especially not best to enter trades when price is at one of the bands.
By introducing an oscillator, traders can filter out the false signals and be able to better pick turning points (short term) in the market. Recommended oscillators include Stochastics or a MACD.