The major stock indexes lend themselves well to using the moving average envelope
indicator to help in trade selection and timing. That is, simple moving average envelope
lines that 'float' 3-4 percent above/below a 'centered' 21-day moving average.
When the market is strongly trending in one direction or another I don't necessarily have simple moving average envelopes displayed on the charts of the major indexes that I analyze weekly on my Index Wrap commentaries.
My first chart provides a current look at what the simple moving average envelope indicator looks like in the current (as of 7/15/11) market. I started using this indicator again more actively when after mid-March it seemed that the market might be moving into a phase where there could be broad two-sided price swings.
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 to help in trade selection and timing. The 'centered' moving average indicator seen when I use this indicator is to set it to a 21 period 'length'; i.e., becoming a 21-day moving average on daily charts and a 21-hour moving average on hourly 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. The upper or lower S&P envelope lines will expand to a value greater than 3% at times when there isa strong trust either up or down. For example, the lowermost percentage could be MORE as prices drop farther in periods of panic selling characteristic of bear market price swings.
The lower envelope line seen below from last year (2010) 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 next chart example, the LOWER 5 percent envelope line was at or near intraday lows in several instances. 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 as this situation may not last for more than a day or two.
Occasional 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 the lows seen in the 2010 chart below), when those same lows were not 'obvious' in terms of a particular retracement level or by some other technical indicator or chart pattern.
The Moving Average Envelope study or indicator used for the major stock indexes 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 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 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 when indicator length is applied to a DAILY chart. I can set my particular technical analysis software (TradeStation) to show the sometimes invisible centered moving average. You don't see the center moving average on some chart applications that provide a version of the moving average envelope indicator.
My favorite moving average length to use for this indicator is 21, which I use on time frames from DAILY to HOURLY mostly; i.e., my indicator set up that way computes a moving average on a 21-day or 21-hour basis. The stock market, especially as represented by the S&P 500 Index or Nasdaq Composite, especially in a trading range situation (broad trading swings, not strong trend direction) 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 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 also 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 percent values to be used for the upper envelope percentage versus the lower envelope line. It is desirable if you can to display the centered moving average 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 if you have one. 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 often 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 the aforementioned 7 points:
I have not used moving average envelopes much on hourly charts, except that with stock 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 as generally too short-term oriented for me; I tend to stay focused on the week to week changes.
In terms of why the 3-5% envelopes, or a bit higher sometimes 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 above at least one 'touch' to the upper and lower envelope lines on the S&P 100 (OEX) 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 more useful trading input consistently out of (in terms of highlighting trading opportunities) using moving average envelopes on long-term weekly charts.
GOOD TRADING SUCCESS!