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Trader's Corner

Moving Average Envelopes

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FIRST, a note to Option Investor Subscribers - Please send any technical and Index-related questions for possible use in my next Trader's Corner article to support@optioninvestor.com with 'Leigh Stevens' in the Subject line.

A major challenge in trading options, especially Index when buying calls or puts, is to know when the particular index or the Market is at an extreme relative to its back and forth price swings. If you are buying when the market is still in a strong move, premiums are inflated or pumped up to attract sellers. If you pay a substantial risk or time premium, you risk being right on the direction of the market but making nothing as the premium erodes more than the point distance covered by a further market move.

Market timing is of course more crucial in options trading than in buying or selling stock - time is not on your side if your trade entry was too soon or too late. You can't hold on to the option like you can a stock, in the hopes that the option will reach a more favorable price at some point.

Moving average envelopes (also known as trading "bands") are a useful technical tool to help us spot the occasional extremes which may be the high and low points for a given period. I use moving average envelopes mostly on DAILY charts.

There are 3 types of the Indicators known generally as envelope "bands": Moving average envelopes, Bollinger Bands, and Kelter channels. Bolinger Bands and Kelter channels build volatility into their equations and are not the subject of this article. "Moving average envelopes" are my topic here.

Moving Average envelopes have THREE component lines. ONE is a line in the center that is a moving average of the daily closing price. [A moving average of the close is simply a price that is the average of some number of days' closes; e.g., 21 days. This number is said to "move" because, at the end of each day, we recalculate the average for the LAST X number of days; "X" is whatever we have set as a "length" for the moving average.]

LINE # TWO is a line that is set to be X percent ABOVE the average (e.g., 3%) - the upper Envelope line.

LINE # THREE is a line that is set at some percentage BELOW the moving average - the lower Envelope line. Usually, but not always, the percent setting is the same for the upper and lower lines or bands -


 

In the moving average envelopes Indicator you can, at most, set
the following different inputs or vary the following:

  1. Type of moving average; e.g., simple, exponential, etc.
  2. Length of the moving average; e.g., the number of trading periods - this will be some number of days' closes on a daily chart, some number of hourly closes on an hourly chart, etc.
  3. A line that is equal to the moving average PLUS some added percent of the moving average; e.g., 3%
  4. A line that is equal to that day's moving average figure MINUS some percent of the average price that day.

In some or many application programs, you will not be allowed to make the upper envelope percentage any greater or lesser than the lower envelope line - in other words, the lower moving average envelope line AND the upper moving average envelope can only be the SAME percentage - there is only one "envelope" percent setting possible.

You can see in the daily chart ABOVE of the S&P 500 (SPX) that I have set the envelopes values slightly differently - the lower line is 2% and the upper line is 2.5%. When using a different percentage for the upper envelope percent versus the lower envelope line percentage, it is not typically a huge variation, perhaps 1/2 or 1% only.

HOWEVER, a half percent difference in an Index can make a significant difference in trading - in the above chart of SPX there were two last "touches" to an lower envelope line when it was set at 98% (envelope line = 2%) of the center moving average, versus NO touches to a line equal to 97.5% of the moving average (envelope line = 2.5%).

The limitation of some charting programs to be able to only set one figure for both the upper and lower envelope lines is a bit of an unfortunate limitation for trading the indices. In the indexes, in an uptrend, the moving average percentage will increase some or slightly on the upper side - that is, the percentage at and under which MOST trading occurs is a bit higher than the lower envelope line; e.g., 3% versus 2%, or 4 versus 5%.

And, for the type of moving average, I use a simple moving average (SMA), so it a matter of adding the closing price of some number of trading periods (e.g., days, hours, etc.) and dividing by this same number, for example the sum of the past 10 closes divided by 10.

My favorite moving average length to use for Stock Indexes is 21, which as I said I use only on Daily charts. The blue chip market as represented by the S&P 500 Index, in an average market cycle or trend duration, will tend to see prices fluctuate in a range that is typically 2-3 percent above or below its 21-day average. As we are interested in also seeing the high and low extremes relative to the envelope lines, bar (or candlestick) charts are used.

In a volatile market, the S&P envelope line can expand to 4% or more, but it won't typically be more than this. With the Nasdaq, this percentage might be 5-6%. The percentage line we are looking for is the one that will then contain within it most of the daily highs and lows that have occurred in the past few months to a year.

In an uptrend I may end up setting the UPPER band at a greater percentage ABOVE the center moving average. In a declining trend that goes on for a long period (a bear market), the declines may bottom at a greater distance BELOW the center moving average.

You'll notice that I am demonstrating the use of moving average envelopes for the Indexes only. Due to the bouts of volatility associated with earnings, business developments, etc., individual stocks tend to work less consistently than for the indexes, which "smooth" out the individual stock "hiccups" and reversals.

Another bar chart with a moving average envelope, that of the Nasdaq 100 (NDX), with moving average envelope lines set at the same values -


 

USE IN TRADING -
In an uptrend, a high probability trade is to buy dips (e.g., buy NDX calls) when prices fall to the lower envelope line. The reverse is true in a sustained downtrend - buy puts on moves up to the upper envelope.


 

There are situations, as can be seen from looking at these charts, that there may be a period of several to many WEEKS where the highs/lows keep bumping against one envelope line or the other. However, after several (e.g., 5-6) weeks of an uptrend or downtrend that has been closely hugging the upper/lower envelope lines, the odds increasingly favor a correction - either a sideways move or a move in the opposite direction - and it can then be favorable to sell option premiums; e.g., short calls or puts.

In a prolonged downtrend/bear market, there will tend to be MORE instances of the index topping out in the area of the "centered" moving average and there will be more "touches" to the LOWER line. The reverse is true in a dominant uptrend or bull market, where there will tend to be a number of lows that are "contained" or held at the centered moving average and more "touches" to and along the UPPER envelope line.

TRADING RULES -
The following characteristics list is one I have used to sum up and categorize the tendencies of market action relative to moving averages and their upper and lower envelopes:

  1. Determination of what moving average to use somewhat arbitrary but is found by what "works" in the most number of markets. The biggest variation is with the percentages above and below this line. I suggest using a 21-day moving average length for the Stock Indices. You can experiment yourself too with different lengths.
  2. A common starting point for the Index envelope size is 3% with the Dow and S&P or 4-5% in the case of the Nasdaq. The envelope size varies from trend to trend and market to market. For an envelope size that "works" - the percent figure that contains within it 90-95% of the price moves above and below the moving average -- start with 3% and expand or contract the envelope size as is appropriate for the dominant trend.
  3. If the last high was 4% above the moving average, the next high will often reflect the same extreme. Conversely, if the last significant downswing low was 3% below the moving average, keep this figure as the lower envelope setting until market action otherwise dictates.
  4. If prices cross above the moving average, assume that this line will act as support on pullbacks and the next rally will have the potential to advance to the upper envelope line. If in an uptrend, the envelope line can act as a rising line of resistance for multiple rallies - the rally tops will "hug" and move up along the upper envelope line. The key thing is that rate of increase will SLOW - the index will not always reverse on move to or above the line.
  5. If prices cross below the center moving average, assume that this line will act as resistance on any rebounds and that downside potential now becomes for a move to the lower envelope line. If the trend is down, the envelope line may act as a falling support line and there may be multiple downswings that touch or "hug" and move down along the lower envelope line.
  6. In an uptrend, the optimum Index Call purchases are the declines to the lower envelope line - this area will both define where the stock or other item is both "oversold" AND the SPECIFIC price area that offers a opportune buying. If in a downtrend, sell advances to the upper envelope line - this area will help define where the market is both "overbought" and the specific price area most opportune as a selling point.

ANOTHER CHART - back when it was QQQ, not QQQQ!


 

In an uptrend, when the index goes through and STAYS ABOVE the 21-day average it usually does it quickly and maintains a pattern of higher highs such as is seen in the QQQQ chart above for several months in 2003, until around year-end anyway.

When a rally after a prolonged uptrend fails very quickly and fairly soon again has a pattern of falling relative highs and lows and, within a few trading periods again falls under the center moving average, it is a pattern that suggests adopting a bearish trading bias.

  1. Even if there is an extension of a price swing to above or below the envelope lines, the probability for a significant further move in that direction is limited, especially if the price swing is a counter-trend move. At a minimum, there should be a reaction (countertrend move) once prices are above or below the envelope line in question.

There is not much more to say about how to use envelopes except to say that the use of this technical indicator gives another kind of an idea about where a market might be at an extreme. While extremes don't happen all that often, when they do there is often a good trading opportunity at hand. And, we don't need more than a few of these to make for a profitable year trading options.

Good Trading Success!!

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