Moving averages (MA) are a popular trading tool. Unfortunately, they are prone to giving false signals in choppy markets. By applying an envelope to the moving average, some of these whipsaw trades can be avoided, and traders can increase their profits. Envelopes trading has been a favorite tool among technical analysts for years, and incorporating that technique with MAs makes for a useful combination. (For background reading on this reliable and useful indicator, see our Moving Averages tutorial.)
What Is an Envelope?
Moving averages are among the easiest-to-use tools available to market technicians. A simple moving average is calculated by adding the closing prices of a stock over a specified number of time periods, usually days or weeks. As an example, a 10-day simple moving average is calculated by adding the closing prices over the last 10 days and dividing the total by 10. The process is repeated the next day, using only the most recent 10 days of data. The daily values are joined together to create a data series, which can be graphed on a price chart. This technique is used to smooth the data and identify the underlying price trend.
(Learning to analyze charts can be a big help when making trading decisions. Check out the Analyzing Chart Patterns tutorial to learn how.)
Simple buy signals occur when prices close above the moving average; sell signals occur when prices fall below the moving average. This idea is illustrated using a historical example in Starbucks shares (NASDAQ: SBUX) from back in 2007. Figure 1 indicates with the large arrows show winning trades, while the smaller arrows show losing trades when trading costs are considered.
Figure 1: The monthly chart of Starbucks shows that a simple moving average crossover system would have caught the big trends
Drawbacks of Envelopes
The problem with relying on moving averages to define trading signals is easy to spot in Figure 1. While the winning trade shown in that chart was very large, there were five trades that led to small gains or losses over a five-year period. It is doubtful that many traders would have the discipline to stick with the system to enjoy the big winners. (For related reading, see Patience Is a Trader's Virtue.)
To limit the number of whipsaw trades, some technicians proposed adding a filter to the moving average. They added lines that were a certain amount above and below the moving average to form envelopes. Trades would only be taken when prices moved through these filter lines, which were called envelopes because they enveloped the original moving average line. The strategy of placing the lines 5% above and below the moving average to form an envelope is illustrated in Figure 2.
Figure 2: Adding lines 5% above and below the moving average forms moving-average envelopes.
In theory, moving-average envelopes work by not showing the buy or sell signal until the trend is established. Analysts reasoned that requiring a close of 5% above the moving average before going long should prevent the rapid whipsaw trades that are prone to losses. In practice, what they did was raise the whipsaw line; as it turned out, there were just as many whipsaws, but they occurred at different price levels. (Learn how a change in market direction can be your ticket to big returns in Turnaround Stocks: U-Turn to High Returns.)
Another drawback to using envelopes in this way is that it delays the entry on winning trades and gives back more profits on losing trades.
Making Envelopes Work Better
The goal of using moving averages or moving-average envelopes is to identify trend changes. Often, the trends are large enough to offset the losses incurred by the whipsaw trades, which makes this a useful trading tool for those willing to accept a low percentage of profitable trades. (For more on identifying market trends, read Short-, Intermediate- and Long-Term Trends.)
However, astute market observers noticed another use for the envelopes. In Figure 3, we show a weekly chart of Starbucks with a 20-week moving average and envelopes set 20% above and below the moving average. Most of the time, when prices touch the envelope lines, prices reverse. But there are some times when they continue trending, leading to losses.
Figure 3: Wider envelopes are useful for spotting short-term trend reversals.
Among the earliest proponents of this countertrend strategy was Chester Keltner. In his 1960 book, "How to Make Money in Commodities," he defined the idea of Keltner bands and used slightly more complex calculations. Instead of using the close to find his moving average, he used the typical price, which is defined as the average of the high, low and close. Instead of drawing fixed-percentage envelopes, Keltner varied the width of the envelope by setting it to a 10-day simple moving average of the daily range (which is the high minus the low). This method is illustrated in Figure 4. (For a closer look at Keltner channels, read Discovering Keltner Channels and the Chaikin Oscillator.)
Figure 4: Keltner bands contain most of the price action, and short-term traders may find them useful as a countertrend system.
Buy signals are generated when prices touch the lower band, represented by the green line in Figure 4. While Keltner bands are an improvement over the set-percentage moving-average envelope, large losses are still possible. As can be seen on the right side of the chart, the last time prices touched the lower envelope in this chart, they continued to fall. A simple stop-loss would prevent losses from growing too large and make Keltner bands, or a simpler moving-average envelope, a tradable system with profit potential for traders on all time frames. (Read about the importance of the stop-loss order in The Stop-Loss Order: Make Sure You Use It.)
Later, John Bollinger built upon the idea of moving-average envelopes and Keltner bands to develop Bollinger Bands®, which enveloped a simple moving average with lines two standard deviations above and below the moving average. This is a mathematically precise way of implementing envelopes to achieve a high number of winning trades because Bollinger Bands® are designed to contain 95% of the price action. (Learn more about Keltner channels and Bollinger Bands® in Capture Profits Using Bands and Channels.)
Moving-average envelopes offer a useful tool for spotting trends after they develop. More precise tools based on the same idea, like Keltner bands or Bollinger Bands®, are useful for identifying high-probability turning points in short-term trends. All traders can benefit from experimenting with these technological tools.