Envelope Technical Indicator: Definition, Functionality, and Example

Discover the Envelope Technical Indicator, its working principles, and a practical example. Enhance your trading strategies with a comprehensive understanding of price chart boundaries.

The Envelope Technical Indicator is a key tool in technical analysis, providing traders with upper and lower boundaries plotted over a price chart. These bounds help in identifying potential overbought and oversold conditions in the market, aiding in making informed trading decisions.

Functionality of the Envelope Technical Indicator

The indicator consists of two moving averages that form a price channel around a central price line. The upper and lower bounds of the envelope are typically set at a constant percentage above and below a moving average of the price.

Calculation Formula

The simple formula involves the following steps:

• Determine the central moving average (MA).
• Calculate the upper envelope: Upper Envelope = MA + (MA * percentage / 100)
• Calculate the lower envelope: Lower Envelope = MA - (MA * percentage / 100)

$$ \text{Upper Envelope} = \text{MA} + \left( \text{MA} \times \frac{\text{percentage}}{100} \right) $$

$$ \text{Lower Envelope} = \text{MA} - \left( \text{MA} \times \frac{\text{percentage}}{100} \right) $$

Types of Envelopes

There are different variations of Envelopes, depending on the moving average used and the percentage:

• Simple Moving Average (SMA) Envelope: Uses the simple moving average as the central line.
• Exponential Moving Average (EMA) Envelope: Utilizes the exponential moving average for more weight on recent prices.
• Weighted Moving Average (WMA) Envelope: Applies a weighted moving average to prioritize specific data points.

Practical Example

Consider a stock whose 20-day simple moving average (SMA) is $100, with an envelope set at 2%. The upper envelope would be:

$$ 100 + (100 \times \frac{2}{100}) = 100 + 2 = 102 $$

The lower envelope would be:

$$ 100 - (100 \times \frac{2}{100}) = 100 - 2 = 98 $$

Thus, the trading channel ranges between $98 and $102.

Historical Context

The envelope technique in technical analysis gained popularity in the mid-20th century. Early technical analysts like Richard Donchian utilized moving averages to identify trends and trading opportunities.

Applicability in Modern Trading

Envelopes are prevalent in modern trading strategies, particularly for:

• Identifying breakout points
• Confirming price trends
• Filtering out market noise

Comparisons with Related Terms

• Bollinger Bands: Similar to envelopes but use standard deviations from the moving average rather than a fixed percentage.
• Keltner Channels: Utilize average true range (ATR) in place of a fixed percentage for the envelopes.

FAQs

• What is the ideal percentage for setting envelopes? The ideal percentage varies by asset and market conditions, but common settings range from 1-5%.

• Can envelopes be used with other indicators? Yes, they often complement indicators like the Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD).

References

1. Murphy, J.J. (1999). Technical Analysis of the Financial Markets. New York Institute of Finance.
2. Pring, M. (2002). Technical Analysis Explained. McGraw-Hill.

Summary

The Envelope Technical Indicator is essential for identifying price boundaries and potential trading opportunities. By setting upper and lower bounds around a moving average, traders can better determine overbought and oversold conditions, and adapt their strategies accordingly.