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Trader's Corner

Using Moving Average Envelopes

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I wrote several articles recently on the use of moving averages in making trading decisions, but did not cover the use of moving average ENVELOPES; or, as are sometimes called, trading 'bands'.

There are basically 3 types of Indicators loosely known as moving average envelopes or trading 'bands':
1. Moving average envelopes
2. Bollinger Bands
3. Kelter channels.

Bolinger Bands and Kelter channels build volatility into their equations and can be used as so-called 'breakout' indicators and are not the subject of this article. 'Moving average envelopes' are my focus here.

Moving Average envelopes have 3 component lines. One line is a moving average and may or may not be shown when moving average envelopes are selected to 'apply' to a price chart. What IS always shown are TWO lines that 'float' above and below the moving average; and most of the price action.

In the moving average envelope Indicator you can at most, set the following different inputs or vary the:
1. 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 periods; i.e., days, hours, etc.
3. A percentage figure ABOVE the moving average in question.
4. A percent figure BELOW the moving average.

In some application programs, you will not be allowed to make the upper envelope percentage any greater or lesser than the lower envelope line; i.e., the lower moving average envelope line AND the upper moving average envelope can only be the SAME percentage; therefore, there is only ONE 'envelope' percent setting possible.

This is a bit of an unfortunate limitation for trading the indexes. In the Indexes, in an uptrend, the moving average percentage will increase on the upper side. That is, the percentage values reached at a typical upswing peak will be higher than the lower envelope line; e.g., 4% versus 3%, or 3 versus 2%.

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 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 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 rally highs and downswing lows that occur.

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.

A bar chart with a moving average envelope follows, which is an S&P 100 (OEX) chart, from the 2003 and 2004 period (the date at the top is todays date). This period was a time when SPX was trading pretty regularly from 2.5% above and 2.5% below the centered (magenta) 21-day moving average line.

The chart below shows the use of the same percentage envelope lines through todays trading. Youll quickly see that due to a lessening of the S&Ps volatility or fluctuations above and below the 21-day simple moving average, there arent any recent instances where the intraday highs or lows come even close to the upper or lower envelope lines.

MIDWEEK TECHNICAL UPDATE NOTE:
The decline below the up trendline dating from the Oct. low, looks like it could well result in a decline to test the prior 578 OEX low, but might not extend all the way to the lower envelope line. The percentage value looks like it needs to be set closer in to suggest the percentage value at which the Index here might be at a lowermost or oversold extreme.

In the next chart I have set or narrowed in the envelope lines considerably, to 1.5% above and below the 21-day average. I did this based on the fact that the LAST two HIGHS were very close to this envelope value. 'As above, so below' pertains here. My lower envelope line ALSO set to 1.5% in the same OEX chart below would be reached at around 580, an area where there is some other technical evidence of support.

In an uptrend I may set my UPPER band at a greater percentage above the center moving average. In a declining trend that goes on for a long period, 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.

In an uptrend, a high probability trade is often to buy Index calls when prices fall to the lower envelope line, assuming OTHER evidence and indications ALSO point to this conclusion. The reverse is true in a sustained downtrend: buy puts on moves up to the upper envelope that has been "containing" the rallies that have occurred in the past 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.

Another example of an EQUAL upper and lower envelope line percentage is seen in the Dow chart below, which reflects the August 2004 to Feb. 2005 period.

However, in recent months the upper end price swings for the Dow have reached approximately 2% above the centered (21-day) moving average and (given the strong Uptrend) only 1.5% below the centered moving average as shown in my next chart of the Dow Average (INDU).

MIDWEEK TECHNICAL UPDATE NOTE:
INDU has touched and, so far, rebounded from the low end of its uptrend price channel noted at the green up arrow in the chart above. My lower envelope band (at 1.5%) or line intersects currently around 11000. Given the current pattern, I do not see the Dow going much below where INDU has reached already in its recent dip.

I tend to put more store, so to speak, in the trendline rebound that just occurred than on lower envelope line considerations. However, if the lower trendline is pierced, a next potential downside target would be to the lower envelope.

With the Nasdaq 100 (NDX) Index, often in recent years the most volatile of the major indices, my envelope setting for the period shown in the NDX daily chart below (2003-2004) was 4% for the upper band and 3% for the lower envelope line. Even here, it's not a huge difference between where the index tops out or bottoms, in percentage terms. However, there are other differences.

The answer to where the (NDX Index went AFTER the period shown above is below. The amount of the decline after February 2004 caused me to set my LOWER envelope line to the same 4% value.

CURRENT NDX CHART PICTURE:
With an upper envelope setting of 3% relative to the NDX and its 21-day moving average, the recent high came right up to the upper envelope line, as did the January peak. The recent low has stopped at the up trendline AND at the 21-day moving average, which suggests that NDX may hold at recent lows. If 1700 gives way then the 1660-1665 area is a next potential downside target.

A revised lower envelope setting at 2%, rather than 3 percent as is shown in the chart above, may be warranted and would suggest a possible oversold extreme at the same 1665 mentioned already. However, I have kept the envelope line setting at 3% above on NDX, based on wanting to keep a visual reminder on my chart as to where a LOW would equal the same percent distance from the 21-day average as was seen at the recent HIGH.

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.

SUMMARY LIST OF MOVING AVERAGE ENVELOPE CHARATERISTICS:

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 around 3% with the Dow and S&P and 3-4% in the Nasdaq. The envelope size varies from trend to trend and market to market. For an envelope size that 'works' or 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 upper 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. In an UPTREND, the envelope line can act as a rising line of resistance for multiple rallies. Rally tops may 'hug' and move up along the upper envelope line. The rate of increase will SLOW, but the index may not reverse in the area of the upper 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 often 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.

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. When a rally 'fails' very quickly and fairly soon again falls under the center moving average, this pattern suggests adopting a bearish trading bias.

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 get very far above or below the envelope line in question.

There is not much more I can 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 index options.

The use of moving average envelopes in individual stocks is not something I can make as many generalizations about. Best moving average length and upper and lower percent values vary to a huge degree.

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MY INDEX TRADER COLUMN:
This Wednesday Trader's Corner article also serves as an adjunct to my weekend 'Index Trader' column. In the article you're reading here I typically also do a brief midweek update of my in-depth weekend column.

You will normally see a web LINK to the Index Trader at the top of your weekend Option Investor Daily e-mail. Moreover, my Index Trader can always be found by going directly to the OptionInvestor.com web site and clinking on the Index Trader section at top.

** Good Trading Success! **
 

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