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Trader's Corner

Moving Average Envelopes

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I received a Subscriber e-mail question on this topic, and will get to that in a moment. Someone wrote our support staff with the following question and I thought I would provide this first as a matter of possible interest to others and as general information:

SUBSCRIBER E-MAIL:
"Is there a way to see (search for) all of the articles written by Leigh Stevens on your site?"

RESPONSE:
[Background note: there is not a search function per se currently on the OIN website, but there is another easy way of finding my articles. I tend to write on different topics in a regular and somewhat methodical way, which over time would re-produce a lot of what is in my book: 'Essential Technical Analysis'. In a way this is a value-added feature of OIN and my particular Trader's Corner articles, at least for those interested in technical analysis; I consider this 'market' analysis, but I do concentrate on technical aspects.]

FINDING PRIOR INDEX TRADER ARTICLES:
My Trader's Corner articles are written by me (Leigh Stevens) on Wednesday for the Option Investor Newsletter (OIN) that is both e-mailed to you and can also be found on the OIN website: click on any prior Wednesday Newsletter; these go back many months. A further click on the Trader's Corner name at top gets you directly to that section without having to scroll all the way down. Prior e-mailed OI Newsletters still in your (e-mail) inbox or in a saved file, are another way to access my prior Trader's Corner columns.

I also write the weekly 'Index Trader' (IT) column appearing usually on Saturday or (sometimes) Sunday, which is found on the OIN WEBSITE ONLY, as it's not weekend e-mailed OIN. [An easy way to go to the OIN web site is via any daily e-mailed Newsletter by use of the note at top: (for an) "online version of this newsletter: 'click here'".] Scrolling back in the INDEX TRADER section allows you to click on and view any and all prior IT articles; these can also be saved as web files.

SUBSCRIBER E-MAIL:
"There are three lines, moving averages I think, usually shown on the charts you use in your commentaries on the weekend. I see a 21-day average, then some percentages given on the other lines above and below. What are these again and how used?

Also since you turned bearish this past weekend, the market has fallen some but not sharply. Before that you were still bullish mor than not. What tipped you the most to the opinion the market would more likely go down than go on to new highs?"

LEIGH STEVENS:
I'll answer on the second part first, then on the Moving Average Envelopes, which is what you're refereeing to.

What got me leaning more bearish or at least cautious on sticking with bullish strategies were two things principally: one was the PATTERN of highs made repeatedly in the same area, in some cases at almost the exact same level in some major indexes, as can be seen in leading S&P 500 (SPX) and Nasdaq Composite (COMP) charts.

The longer that a market goes basically sideways after a strong and prolonged move, the more likelihood that a top is forming. However, there are, as of yet, no 'confirming' downside penetrations of prior (down) swing lows. So, the market is still kind of in no man's land so to speak.

The market could be building a top as signaled by the lack of buying follow through, coupled with repeated selling interest in key price areas; however, selling also has been drying up once the major indexes get much lower. The S&P 100 (OEX) and the Dow 30 (INDU) have formed possible double tops to boot.

Fundamentally, I figure that stock prices are pretty much in equilibrium ahead of more information; i.e., how earnings fared in the fourth quarter (Q4). We have earnings coming out in January, and there are a number of cross currents on how strong was the finish to the year. The market may be showing in its technical/chart patterns that they won't be good enough to push stocks much higher for a while. And, seasonally, there's a tendency to sell off in January.

The other factor that was my principle negative was that my 'sentiment' INDICATOR last week indicated a continued high bullish interest in calls. So high, that it suggested, along with the chart patterns, the contrary possibility of the market falling into a deeper correction than we've been seeing since when this current rally began in early-October.

Some charts, will illustrate both the moving average envelopes I keep up a lot as 'references' in the major indices (for where prices are in a typical trading range), and the other points about pattern and my 'sentiment' indicator:

CHART 1: S&P 500 (SPX); Daily

The S&P 500 built a top over a three day period at 1275. Of course the Index had stalled before this, not far under, in the 1266-1270 area. The tipping point to a more bearish viewpoint were intraday highs made three days running at 1275.

However, it also should be noted that the recent swing lows around 1250 have not been pierced either. SPX is in limbo so to speak. I don't want to be in calls and would rather be in puts at 1270 and above, allowing me to set an exit point/stop at 1277, with downside potential looking to be 1250, perhaps back to the trendline around 1230-1235.

The moving average in a MOVING AVERAGE ENVELOPE indicator is called the 'centered' moving average. The lines above and below this average are set to equal some percentage above and below the centered moving average. Often this percentage moving average indicator is displayed WITHOUT the moving average that it's based on. The S&P indexes tend to fluctuate from around 3 percent above and 3% below the 21-day average. Due to somewhat less volatility in recent months, I've set the lower and upper lines at 2.5 percent. More on the purposes of this indicator further on.

CHART 2: S&P 100 (OEX); Daily

The dominant or stand out feature technically of the S&P 100 (OEX) chart was the possible double top, relative to OEX's March price peak. It's also true that OEX was hitting highs at same level in several sessions; i.e., 582.6-583. But what trumps this so to speak is that we have this prior high made some months back that was touched once, making an exact double top. Double tops, separated by some weeks or months (even years) are frequently quite meaningful, suggesting places for at least a trade in options, sometimes also signaling a major top.

The spike up in my 'sentiment' indicator shows the recent spike up to a day where the daily volume on CBOE equities calls was 2.4 times the same day's put volume. The number of high readings also pulled the 5-day average up to 2, which is not greater than any prior period in the chart shown above, but the one-day reading IS. This kind of peak suggests a high degree of bullishness as suggested by call volume relative to puts.

A high degree of bullishness, coming at a time when the market is significantly stalled, is suggestive that the market is at least vulnerable to coming down. Sometimes, most traders are highly bullish or highly bearish and are RIGHT. It's just not that often!

As with most aspects of technical analysis, patterns tend to repeat. That's why this form of analysis 'works' as well as it does, which is not all the time but often enough that you can make money using it. The probabilities involved in this is why I always suggest playing the percentages; e.g., what is the risk in shorting at a repeated high, using a stop just over that high, versus the reward potential of a significant correction? Usually, the odds favor this kind of trade. When wrong, loses are relatively small. When right, the profits are good. Add up a few trade like this and it's a winning year. But I digress!!

CHART 3: Nasdaq Composite (COMP); Daily

The Nasdaq Composite (COMP) Index keep hitting repeated highs around 2275-2275 and has experienced a fairly sharp correction from this area, once it fell under its 21-day moving average. However, it also has held at and rebounded some from its relatively steep up trendline. This action suggests that the strong up trend has not been 'broken' so to speak, at least not yet.

Now is where the LOWER envelope line comes into play as a kind of 'benchmark' on the downside possibilities in a 'normal' trading range for COMP. If COMP were to fall to the lower envelope line in the chart above, and this would be likely if the Index fell again under 2215, a possible downside target becomes 2164, at the green lower envelop line. Now would be a time to go into the Moving Average Envelope study a bit more as to why this might be a good indicator to follow.

THE MOVING AVERAGE PERCENT ENVELOPE (MAPE) INDICATOR

I will use some charts from PAST periods as illustrations from this point on. I also 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, but, as I noted, the moving average in the center is not always shown. However, you can then always apply a simple 1-line moving average set the number of days on which the envelope percentages are based and you then see the center moving average which I find invaluable.

In the moving average envelopes Indicator you can at MOST, set
the following different inputs by varying 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; e.g., 21-days on daily charts which I use most often.
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 in some charting applications. 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.

I use for Stock Indexes a 21-period moving average, on daily charts only. The blue chip market segment, as represented by the S&P 500 Index (SPX), in an 'average' market cycle or trend, will tend to see prices fluctuate roughly 90-95% of the time in a range that is 2-3 percent above or below an SPX 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 the S&P 100 (OEX) chart shown below; to 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' like in the chart above. There are also instances where a touch to the upper or lower envelope line also coincided with, or were in vicinity of, extremes in key technical markings like trendlines. The convergence of a low or high reversing from both an envelope line AND a trendline can be a more 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 to the 580 area, might mark a 'final' top for the advance prior to a corrective and tradable downswing.

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 2 2.5 percent, as has been the case for most of this year.

With the Nasdaq, this percentage range will tend toward 3.5 to 4, even as much as 5-6 percent; I typically start with around 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'll note, as in the daily chart of the Nasdaq 100 (NDX) chart below, a tendency for prices in the strong up trend shown, as well as in Chart 3 above, the tendency for the advance to keeping going up but to 'hug' 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 on the chart below was also the second touch, but prices did not keep going down along 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 and best place 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 often 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 several weeks (e.g., 3-6) 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 NDX chart one chart back from the one directly above, both envelope lines are at 4%. I tend to adjust these lines from time as volatility increases or decreases.

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.

MY 7 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 good trading opportunity; not more than a few of these make for a profitable year trading options.


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** Good Trading Success! **
 

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