An envelope is a technical analysis tool used by traders to identify potential support and resistance levels for a financial asset. It consists of two parallel lines plotted above and below a moving average, with the space between the lines representing a percentage deviation from the moving average.
Calculation of Envelope
To calculate an envelope, traders typically use a simple moving average (SMA) of the asset’s price over a specified period. The upper and lower lines of the envelope are then plotted a certain percentage above and below the moving average, typically ranging from 1% to 10% or more, depending on the trader‘s preferences and the volatility of the asset.
Purpose of Envelope
Envelopes are used by traders for several purposes:
- Identifying Overbought and Oversold Conditions:
- Envelopes help traders identify potential overbought and oversold conditions in a financial asset.
- When the price moves above the upper envelope, it suggests that the asset may be overbought and due for a pullback.
- Conversely, when the price moves below the lower envelope, it indicates that the asset may be oversold and poised for a rebound.
- Trend Identification:
- Envelopes assist traders in identifying the direction and strength of the trend.
- A widening envelope suggests increasing volatility and a strengthening trend.
- Conversely, a narrowing envelope implies decreasing volatility and a potential trend reversal.
- Trading Signals:
- Envelope crossovers can serve as trading signals for traders.
- A buy signal may occur when the price crosses above the upper envelope.
- Conversely, a sell signal may be generated when the price crosses below the lower envelope.
- These crossover signals are often confirmed by other technical indicators or price patterns.
Example of Envelope
For instance, if a trader plots a 20-period SMA on a price chart and sets the envelope width at 2% above and below the SMA, the upper envelope line would be plotted 2% above the SMA, and the lower envelope line would be plotted 2% below the SMA. This creates a channel around the moving average within which the price tends to fluctuate.
Limitations of Envelope
While envelopes can be useful for identifying potential support and resistance levels and trend direction, they are not foolproof and may generate false signals, especially during periods of low volatility. Traders should use envelopes in conjunction with other technical analysis tools and risk management techniques to validate signals and manage trading risk.
