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Trader's Corner

Moving Average Envelopes 

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This Trader's Corner article is a continuation of what I wrote a week ago in this space, when I discussed Bollinger Bands, and how they differed from Moving Average Percent Envelopes (MAPE), which are commonly called simply Moving Average Envelopes; sometimes, just 'envelopes' or moving average 'bands'. 

I'll recap just a bit on Bollinger Bands. My prior article, in its entirety, can be seen on 6/15 OI Newsletter by clicking here

BOLLINGER BANDS  
Bollinger Bands consist of a set of three 'bands' drawn in relation to an index, stock or any financial instrument. The middle band is a 20-day simple moving average, that is not usually shown, but serves as the base for the upper and lower Bollinger Bands (BB). 

The interval between the upper and lower bands and the middle band is determined by volatility, typically the standard deviation of the same data used for the average. The default parameter is 20 periods and 2 standard deviations.

"Standard deviation" describes how prices are arrayed around an "average" value. One standard deviation is a set of values that contains close to 70% of the price fluctuations that occur above and below the moving average used in the Bollinger band 
calculation. 95% of the fluctuations will occur within two standard deviations of the moving average in question. 

The purpose of the BB Indicator is not that different from the "moving average envelope" indicator: are prices 'high' or 'low' on a relative basis? 

With the BB indicator, the two bands (calling these lines "bands" helps distinguish them from the fixed percentage "envelope" technique) are placed above and below the centered, unseen moving average. The average is usually, but not always, set to a 'default' setting of 20 by the charting software. If not, you can change to a length setting of 20. 

John Bollinger indicates that he considers it a key factor to be what can be derived from "BandWidth"; from BandWidth, can be derived something he calls "The Squeeze": a volatility-based trading opportunity. 

When the distance between the bands substantially narrows in from a usual pattern with a stock or index, it may be time to look next closely for signs of a break out move, above or below any recent narrow trading range. 

Good examples of such "squeeze" opportunities or narrowing in of the bands are seen in the S&P 100 (OEX) chart below. The squeeze in the Bolli Bands outlined by the two instances below, where the narrowness shown by parallel horizontal (cyan) lines, highlight a reduced volatility and are followed by a sharp expansion of the bands, may be characteristic of some major tops:

At the two significant bottoms shown in the OEX daily chart above, as outlined by the two blue circles, volatility was high and the Bolli Bands had expanded to a greater than usual degree. 

Maybe this is something to look for at major bottoms; however, it can't be said to be always true, as can be seen in the next chart (lower, far left), which takes us back to the 2003 bottom in OEX:

Of course, this is all relative, as the narrowing squeeze in the BB in early '03 was nothing like witnessed in the more reduced volatility seen at the two tops seen in 2004. However, relative to what had come before, they were significantly narrow. 

Which brings me to the point I always make about INDICATORS: they are not usually best used, or cannot usually be used, as 'mechanical' signals. 

As part of trading systems, yes; such systems may have indicator-based entry defined in certain ways, with entry rules refined by back-testing, etc. However, in trading decisions based on experience and study of various technical and fundamental aspects of the trend, indicators provide helpful clues sometimes; but not always and not always in the same way. 

MOVING AVERAGE PERCENT ENVELOPES (MAPE)  

I'll refer initially to Moving Average Envelopes as Moving Average PERCENT Envelopes, to reinforce the idea that these bands or envelope lines are set to equal a fixed percentage above and below the changing (each day's) moving average; e.g., lines that are set to equal 3 percent above and below the moving average. 

There is not a set "default" for the Moving Average. Usually, but not always, the percentage above AND below is the SAME. In some software applications, the upper and lower line MUST be the same since the application allows only ONE input. 

The moving average (percent) envelope indicator has 3 component lines, as does Bollinger Bands (BB); however, the moving average above and below which the BB lines are traced, is not shown. It is shown in the MAPE. 

In the moving average envelopes Indicator you can at most, set 
the following different inputs or vary the: 
1. The type of moving average; e.g., simple, exponential, etc.
2. Length of the moving average; e.g., the number of trading 
periods - averaging 10, 20 or 30 days; or, hours, etc. 
3. Percentage figure above the moving average in question. 
4. Percent figure below the moving average.

Not being able to set different moving averages (above and below) is a minor limitation for trading the indices. In an index uptrend, the moving average percentage will tend to increase 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., 3.5% versus 3%, or 2.5 versus 2 percent. 

Most of the time, a simple moving average (SMA) is used, 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 I mostly use on Daily charts only. The regular 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 90-95 percent of the time in a range that is 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, as in today's S&P 100 (OEX) chart below on which is applied the moving average envelope indicator using upper and lower envelopes lines of 1.5% and 2%, respectively.

A number of down (red) arrows, indicating precise or approximate areas of resistance, are applied at different points by way of illustration of where the upper envelope line OR the moving average acted as resistance, even if this was temporary. 

Conversely, the up (green) arrows, indicating precise or approximate areas of support, are applied at different points by way of illustration of where the lower envelope line OR the moving average acted as support, even if that was temporary. 

There are some instances where the upper or lower envelope line also intersected an existing, or the start of, a trendline; e.g., such as those defining a price 'channel'. There are also instances where a touch to the upper or lower envelope line also coincided with, or were in vicinity of, extremes in OTHER key indicators. The convergence of indicator extremes can be a definitive sign of a possible intermediate top or bottom. 

Often it is the second touch to the upper or lower envelope line that marks a 'final' top or bottom for that move. So, for example in the chart above, another push in the OEX up the 580, or higher (e.g., 585) area, might mark a 'final' top for this current uptrend. 

In a volatile market, the S&P envelope line can expand to 4% 
or more, but it won't typically be more than this; in a less volatile market trend, the envelope range might be 1.5 2.5 percent, as it is currently. 

With the Nasdaq, this percentage range will be 4 to as 5-6 percent or more; I typically start with a 4 percent envelope in the Nasdaq indices and see if MOST of the trading is occurring within an envelope line of that percentage. The percent line we are looking for is the one that will contain within it most of the daily highs and lows that occur WITHIN the past 6-12 months. 

You note, as in the daily chart of the Nasdaq 100 (NDX) chart below, a tendency for prices to go up "hugging" the upper envelope line. There is less of tendency with tops, for the first 'touch' to the upper envelope line to mark a 'final' top. 

The final NDX bottom was also the second touch, but prices did not 'hug' the line. There was an attempt to rally, followed by a sideways trend, then a couple of drops, one sharp, then a final 'touch' to the lower envelope line. This was 'the' bottom were looking for to cover puts and buy NDX calls. 

I usually use 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.

In an uptrend I often 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 will typically bottom at a greater distance BELOW the center moving average. There is not typically a huge gap between the upper envelope percent and the lower envelope line percentage; e.g., a half percent, more rarely, especially in Nasdaq, a full percent such as from a prior period in NDX below:

In an uptrend, a high probability trade is to buy dips (e.g., buy Index 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, at least one that has been "containing" the rallies that have occurred in the past 6-9-12 months. 

After about 6 weeks of an uptrend or downtrend that has been closely hugging the upper/lower envelope lines, the odds increasingly favor a correction and can be favorable to a bet on at least a sideways trend ahead which suggesting selling option premium; e.g., shorting calls or puts. 

As I mentioned already, often in recent years in the Nasdaq 100 (NDX) Index one of the most volatile of the major indices, my current settings for the two envelope lines may be as much as a percent difference; e.g., 4% for the upper band, especially in an uptrend and 3% for the lower envelope line. However, currently, as can be seen in the current NDX chart (one chart back from the above one), both envelope lines are at 4%. 

In a prolonged or dominant uptrend, 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. In a prolonged downtrend, there will 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 envelope
line. 

SEVEN TRADING RULES OF MOVING AVERAGE ENVELOPES: 

1. Determination of what moving average to use somewhat arbitrary but is found by what 'works' for the past 6-9-12 months to contain within the lines most of the highs and lows. The 
variation is with the percentages above and below this line. I don't vary the 21-day moving average length for the stock indices. You can experiment yourself with different lengths.

2. A common starting point for the Index envelope size is 3% with the Dow and S&P and 4-5% in 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 for the past 6-12 months. 

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 opportunity. 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. 

7. 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, it often marks a very good trading opportunity. And, we don't need more than a few of these to make for a profitable year trading options. 

Good Trading Success! 

NOTE - 
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. 

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