The Beginner’s Guide to Technical Analysis Part 7 – Bands and Envelopes
Technical Analysis is a curious pursuit.
Charts attract all walks of life; not just those mathematically inclined.
Maybe the rhythmic patterns appeal to us on a deep level. The harmony of the price movements touches something primordial in us…
Perhaps we enjoy the puzzle. The interplay of indicators challenges us to master something we never quite can… the perfect puzzle to enthral us.
Then again, the sceptic might say it’s because we are monetarily inclined. We are here to make some dough.
The truth is it’s likely a mix of all of the above (and more). Without money to keep score, would the game be as much fun? Without the challenge, would we be so interested in making money in the market over, say, starting a business in something we were passionate about?
For the aspiring technical analyst, bands and envelopes are the ideal lure. These indicators pair pattern recognition with practical application.
They have utility for trading both ranges and trends, making them some of the most flexible indicators in your trading toolbox.
But perhaps more importantly, they provide a crucial framework for your trading.
The critical importance of having a framework for your trades
Too many traders are looking for the Holy Grail trading strategy. That is, a set of rules that will work in all conditions.
But this is not what top traders do. Top traders have a framework for their trading, so they can apply the appropriate strategy at the correct time.
By knowing how and when to trade profitably, you can position yourself ahead of the pack.
Bands and envelopes are a fundamental part of this framework. A careful application of the techniques in this article will help you determine which approach to use at the right time.
This is a crucial step that most traders fail to take. But with Bands and Envelopes it does not have to be that way for you.
Bands and envelopes will tell you if you should be bullish or bearish. They’ll tell you if you should be trading with the trend, or applying a reversion to the mean approach – if the market is overbought or oversold, about to reverse, and more.
These were invented in the 1980’s by John Bollinger, to factor in the volatility of the price along with the trend.
Bollinger bands measure the standard deviation of the price from a moving average (typically 20 periods), and have a wide variety of uses.
Bollinger bands are used to trade a range or reversal. When the price hits the upper or lower bands it is an indication to sell or buy respectively.
This can be particularly effective when the bands are wide (meaning the price is more volatile) and the price is trading within a range (as opposed to trending).
You can combine this technique with a candlestick reversal pattern, support and resistance levels, or an overbought/oversold reading on an oscillator like RSI or stochastics.
Bollinger bands are also used for capturing trends.
You can trade a breakout when the price closes over the Bollinger Bands. This is most effective when the Bollinger Bands have condensed into a tight range.
Another use of Bollinger Bands is for market type identification. As mentioned above, it is important to trade the right strategy for the current market type. You can read more about this here.
Moving Average Envelopes
Moving Average Envelopes provide context to the price. They act as a roadmap of sorts, to guide your trading decisions.
Envelopes are simply the standard deviation of the underlying moving average envelope. Unlike the Bollinger Bands, they do not contain a volatility component.
While you can use a single set of envelopes on their own, you might find it more useful to use 2 or 3 sets at different levels of deviation, along with a moving average.
Here you can see two sets of envelopes and a moving average (the red line)
Configuring envelopes needs to be done separately for each pair and timeframe you trade. As a general rule, you want the first set of envelopes to encompass around 80% of the price movements.
The wider set of envelopes should encompass around 95%, with the price falling outside of them a maximum of 5% of the time. You may need to adjust these rules over time to ensure the envelopes continue to fit these conditions.
Unlike some other indicators, envelopes don’t provide you with specific entry signals, rather they act as a framework.
Here is how they can be interpreted:
If the price is winding around the central moving average, the trend is flat or weak.
If the price is moving with the upper mid envelope and the envelope itself is pointing upwards then the trend is bullish. The reverse is true for a bearish trend.
If the price is trading between the upper-mid envelope and the upper-outside envelope then the trend is strong. The reverse is true for a bearish trend.
If the price is trading beyond the upper outside envelope, then conditions are at extremes. You can expect a reversal or pull-back.
Be careful here. The price can still continue in the direction of the trend for some time before reversing, so it may be best to wait for a confirmation signal from the price, or another indicator such as the RSI or Stochastics.
By applying bands, we can judge volatility and jump aggressively on possible breakouts. By constructing envelopes, we can trade within a calm and collected framework.
If charts are your thing, then these indicators can make them tell you a compelling story. If you apply your best technical judgement, you can greatly increase your success in the markets.
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