Hunting Key Levels Using 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, and one shifted below. If the market price breaks through these bands, we may assign some significance to the move and trade accordingly.
Calculating the Level of the Trade 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. 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 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 4
You will find the envelopes in MetaTrader 4 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 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:
Source: MetaTrader 4 - Editing the parameters of the Envelopes indicator
'Period' is the window over which we average our values to construct our moving average lines. The default value is 200. Normally, it is suggested to start with default values when first starting to use an indicator, but this is a very long period, and you may find a smaller value to be more usable.
The default value of 200 provides a very smooth curve that may lie far 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 by 10 bars, while a value of -10 would move them back by 10 bars, and so on.
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' 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 that the moving average will be shifted up and down 0.5% in value. In the image below, we have added the Envelopes indicator, using 20-period SMAs of the closing price to an hourly GBP/USD chart:
Depicted: MetaTrader 4 - price data from Admiral Markets - hourly GBP/USD chart - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.
We 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.
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.
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.
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 display 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.
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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, rather 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 MT4 will turn like a tanker.
The lag is much greater than with a shorter, more responsive MA, but in turn, they 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 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 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 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 keen 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 Envelopes 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 and the Williams Percent Range indicator to a 5-minute GBP/USD chart:
Depicted: MetaTrader 4 - price data from Admiral Markets - 5-minute GBP/USD chart - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.
The settings we used for the Envelopes were a period of 50, a deviation of 0.15%, with a method type of the EMA 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. We set the Williams %R to a period of 50 also.
The rules for this system would be:
- Enter a long if the price breaks (closes) below the lower envelope and %R shows that it is oversold
- Enter a short if the price breaks above (closes) above the upper envelope and %R shows that it is 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 the %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 the MetaTrader Supreme Edition plugin. MTSE is available 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
Remember, building a complete Forex Envelope profit system 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. We hope you have found this introduction to the Envelopes Indicator to be useful.
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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.