The major stock indexes lend themselves well, not all the time but often enough, to make a useful tool of the moving average envelope
indicator in trade selection and timing. The 'centered' moving average indicator seen in my first chart is set to a 21 period 'length'; i.e., becomes a 21-day moving average on daily
charts. The upper and lower envelope lines get adjusted up or down from a starting point of 3 percent above and 3 percent below the 21-day average; the moving average changes, the envelope values also change.
In a weak period like we're in currently, the upside in the S&P especially tends to be 'contained' by a 3 percent envelope line, whereas the lower percentage is MORE as prices drop faster and further in periods of panic selling characteristic of bear swings.
The lower envelope line seen below is adjusted according to the downside volatility; in this case to 5%, from 3%. Such an 'expanded' envelope line will then often 'work' well in defining future instances where downswing lows (e.g., at 5% under the average) are close to or coincide with the lower envelope line. Conversely, highs bump into apparent resistance at the upper line.
In my first chart example, the lower 5% envelope line has been at or near intraday lows in recent months; 90% or more of the time. Since trading options, whether in indexes or in stocks is a percentage game, it pays to take note of the odds against any major further down leg that is much beyond the lower envelope line or not for long; e.g., a day or so.
Occasion checking of where any of the major indexes are in terms of the envelope line method I've outlined here, can give added insight to where 'support' might lie (e.g., at recent lows), when it was not obvious in terms of a particular retracement or by some other indicator or pattern.
Here's an indicator in the Moving Average Envelope study that can help figure out where potential support or resistance areas lie. And, what price areas suggest where an index or stock may be temporarily overbought or oversold. This is a big leg up on conventional 'overbought/oversold' indicators that only attempt to define 'extremes' without giving us a clue of a price area, that when reached, is ripe for a turnaround.
The moving average envelope study or indicator is comprised of an upper and lower line that 'floats' at a set percentage above or below a particular moving average; in my examples, a 21-day average. My charts will show the sometimes invisible so-called centered moving average. You don't see the center moving average on some chart applications of this indicator.
My favorite moving average length to use for this study is 21, which I use on time frames from Daily to Hourly; i.e., 21-days, 21-hours. The stock market, especially as represented by the S&P 500 Index and in a trading range market will tend to see prices fluctuate in a range that is approximately 3-4 percent above or below the 21-day moving average on bar or candlestick charts.
In a strong trend in the indexes, the upside OR downside band or envelope will tend to be where the band or envelope line expands beyond 3%. You may notice that I demonstrate 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.
Remaining chart examples are taken from my database of past similar patterns or are from my (Essential Technical Analysis) book.
The 10-year U.S. Treasury note, which has replaced the 30-year long bond as the most active government, in either cash or futures markets, is very similar in its behavior relative to trading plus/minus 3% above or below its 21-day average. More volatile stocks or volatile indexes in certain periods may regularly trade 5-10 percent or more above or below a 21-day moving average. The percentages best used as the envelope values, will vary substantially between individual stocks and from one type of market to another; e.g., whether a moderate to strong market trend and in which direction, since bull market cycles have some different characteristics than bear markets.
In a bull market, the upside rallies will usually extend to a greater percentage and the downside will be contained by a lesser percentage; e.g., 5% on the upside, 3% on the downside or vice versa.
Some charting software unfortunately will not allow different numbers to be used for the upper envelope percentage versus the lower envelope line. It is also desirable usually to also display the moving average, the center line, due to the average sometimes being a 'mid-range' support and resistance area. Someone looking for trading opportunities, either just on the side of the dominant or major trend or, on both sides of the market, can benefit from using the moving average envelope indicator.
Traders, particularly in the indexes, who are looking for initial or additional entry buy points can often improve their entry point if they wait for prices to dip to the lower envelope line. This will tend to mean trading LESS, which should only make your broker unhappy. A seller/put buyer should do the reverse and watch rallies for an approach to or above the upper envelope.
It is worth saying again that in a bull market the UPPER band will tend to see highs that are a GREATER percentage value above the 'center' moving average than the lower line. In a bear market, the reverse tends to be true and the declines will typically bottom at a further distance from the centered moving average; e.g., prices fall to lows that are 5% under the moving average, versus 3% as the value set for the upper envelope line.
In a downtrend 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 strong uptrend or bull market, where there may be a number of lows that are contained or find support at the centered moving average and more touches to and along the UPPER envelope line.
The following 7 characteristics, are my 'rules of thumb' that suggest tendencies of market action and behavior that are commonplace 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 instances or trend reversals. The biggest variation is with the percentages above and below the center moving average. I suggest starting with a 21-day moving average for most daily charts in stocks, most commodities and for other markets.
2. A common starting point for a major index envelope size is 3-4 percent. The envelope size varies from trend to trend and market cycle to market cycle. For an envelope size that has 'worked' the best for me in trade timing over many years of trading the indexes start with 3 percent envelope side as your default setting and then expand or contract the envelope size (the percentage) as is appropriate for the dominant trend, especially over the past 6-12 months.
3. If the last high was 5% above the moving average, try keeping the upper envelope line set at 5%. 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 dictates otherwise.
4. If prices cross above the moving average, assume that this line will act as support on pullbacks with the next rally having good potential to advance to the upper envelope line. If the index or stock is in an uptrend, the envelope line often acts as a rising line of resistance for multiple rallies that 'hug' (move up along) the upper envelope line. The key thing is that rate of increase will tend to SLOW. The index will not always reverse on a move to or above the line, it just slows down its rate of increase.
5. If prices cross below the center moving average, assume that this line may act as resistance on any rebounds and that downside potential is 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, buy declines to the lower envelope line; this area will both define where the index or stock is both 'oversold' and the specific price area that offers an opportune buy. In a downtrend, I look to sell advances to the upper envelope line; this area will help define where the market is both 'overbought' and the specific price area that may be most opportune for shorting or put entry.
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.
My next chart provides some further illustration of these points:
I have not used moving average envelopes as much on hourly charts, but with index options, moving average envelopes work well in general. I usually keep a 21-hour moving average on my hourly charts, while not often also evaluating envelope lines being a little too short-term oriented for me as I try to stay focused on the week to week changes.
In terms of why the 3-5% envelopes, or a bit higher in the Nasdaq, work regularly and well in the major stock indexes is that the price of having many stocks combined into one index 'smoothes' out the index; whereas an individual stock can really tank or jump on some big news event. With the indexes however, the envelope lines end up being at or near most of the dominant daily highs or lows; sometimes this same pattern appears on a 60-minute chart basis, as can be seen with the S&P 100 (OEX) hourly chart below.
We see at least one 'touch' to the upper and lower envelope lines above over a number of price swings. Sometimes, especially in a steep decline, an index will break through the percentage envelope that has been generally or heretofore 'working' in terms of measuring the extremes for that index in that TIME frame; e.g., within the last 2 to 6 weeks on an hourly chart basis and the last 3-6 months or 12 months or longer in the daily charts. I have had only limited success in getting something out of (in terms of highlighting trading opportunities) using moving average envelopes on long-term weekly charts.
GOOD TRADING SUCCESS!