Hunting Key Levels With the Envelopes Indicator
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 to a certain distance above the price and the other shifted below. If the market price breaks through these bands, we may assign some significance to the move and trade accordingly.
In this article, we will tell you everything you need to know about the Envelopes indicator, show you how to use it in both the MetaTrader 4 and MetaTrader 5 trading platforms, provide an example of an Envelope indicator strategy and much more!
Table of Contents
Calculating the Level of the Envelopes
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, which is usually 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 via the two following equations below:
- Upper envelope = SMANx X [1 + D%]
- Lower envelope = SMANx X [1 - D%]
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 5
You will find the envelopes indicator in both MetaTrader 4 (MT4) and MetaTrader 5 (MT5) as one of the standard trading 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 indicator in MT4 and MT5 is classified as being a trend indicator and can be found in the 'Trend' folder in the 'Navigator' window of both platforms, as you can see from the screenshot below:
Source: Admirals MetaTrader 5 - Envelopes Indicator Settings
The image above shows the default settings for the Envelopes indicator in MetaTrader 5, which can be adjusted as desired. Although it is normally suggested when using an indicator for the first time to start with the default values. Let's take a look at each of these parameters and how they affect the Envelopes indicator.
Period
'Period' is the window over which we average our values to construct our moving average lines. The default value in MetaTrader 5 is 14.
The higher the period, the more price data the envelopes indicator utilises and the smoother the curve will become. Higher values will better suit those who are looking to trade infrequently as they may produce envelopes which are further away from the price.
Shift
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 by 10 bars, while a value of -10 would move them back by 10 bars, and so on.
Method
The 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 decreases exponentially for each successively older price in the series.
Apply To
'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
'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 0.1, meaning that the moving average will be shifted up and down 0.1% in value.
In the image below, we have added the Envelopes indicator using the default settings to an hourly chart of GBPUSD.
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Envelope Indicator 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.
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 indicator, it displays 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, the 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 trading discipline and nerves.
A Lagging Indicator
The third aspect we mentioned was that moving averages are what is known as 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 also see the moving average 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 occurs 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 MT5 will turn very slowly.
A shorter, more responsive MA will display a clearer picture of the market in which you can have greater confidence. Envelopes with a smaller value for the '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 putting your capital at risk. This is why a risk-free demo trading account is so useful for traders. It allows you to trade with real-market data, but using virtual currency to eliminate the risk while you are determining what works.
Turning Points in Market Price
Now let's go back to our second point from above, which was the trend-following aspect. There are two ways of looking at the same indicator. To reiterate, we stated before that a breakout may result in an enduring trend, but more frequently we will see the trend break down and prices 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, however, might be interested in the other side of the coin.
Such a trader might see the opportunity to make frequent smaller profits, albeit with the risk of an occasionally large loss. Such a strategy clearly relies on solid risk management, as the long-term success will entirely depend on the ability to dodge the bullet of being on 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 the Envelopes indicator to pick key price levels, then an oscillator to confirm that the market is acceptably oversold or overbought.
On the chart below, we have added the Envelopes indicator, an Exponential Moving Average (EMA) and the Williams Percent Range indicator to a 5-minute EURGBP chart:
The settings we used for the Envelopes were a period of 50, a deviation of 0.15% and with a method type of exponential applied to the close. We also added a regular EMA with a period of 50, which is the green, dotted line that lies in the middle of the Envelopes indicator. The Williams %R was also set to a period of 50.
The rules for this system would be:
- Enter a long position if the price breaks (closes) below the lower envelope AND the %R shows that it is oversold (i.e. below -80)
- Enter a short position if the price breaks (closes) above above the upper envelope AND the %R shows that it is overbought (i.e. above -20)
The vertical red 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 the %R is in oversold territory.
The first target level would be if the price crosses back above the central green line. A secondary, more aggressive target level would be if the price reaches the upper envelope.
You would 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 13 pips in this example.
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 the MetaTrader Supreme Edition plugin. MTSE is available exclusively from Admirals as a free download, and offers a more extensive range of indicators compared to what you will find in the standard versions of MetaTrader 4 and MetaTrader 5.
Envelopes Indicator: Conclusion
We hope you have found this introduction to the Envelopes Indicator to be useful. Remember, building a complete Forex Envelope indicator strategy is not just about signals informing you when to buy and sell. Obviously any trading system needs to inform you about the 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 you should have a systematic process for exiting both winning and losing trades.
For beginner traders, or experienced traders looking to implement a new trading strategy, it is always recommended to practice on a risk-free demo trading account before heading to the live markets.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
