In the previous lessons, you’ve learned the importance of moving averages (MA) to analyze the historical trend of the forex market.
Let’s review:
But here’s the thing – MA is susceptible to false signals, especially when used alone.
To address this weakness, traders use the Moving Average Envelope (MAE). It consists of two percent-based (5%) bands above and below the moving average.
MAE is among the favorites of forex technicians. It’s easy to use and extremely valuable in risk management as it helps you avoid market whiplash.
In this lesson, we’ll discuss the concept of the moving average envelope, discover its potential, and learn how to use them in trading.
The forex market is extremely complex as it moves depending on multi-layered factors. That’s the elephant in the room.
And when you want to profit from it, you must be skilled in identifying the market’s future direction (whether it appreciates, depreciates, or consolidates)
While technicians do not have a crystal ball to predict the future, they do have tools that help them make sense of the prevailing trend and, ultimately, identify its future direction.
The commonly used technical indicators are the moving averages (MA).
MAs are trend-following indicators that smooth out the price data over a specified period. It’s easy to use and does provide signals that are easy to interpret.
As the name suggests, MA takes the average closing prices of the asset over a specified period (20-day, 100-day, or 200-day periods). The moving average is then plotted in the trading chart to help analysts visualize the relationship between the current and average prices.
Finally, this indicator provides insights into the changes in trend and the potential price reversal.
| Type | Market Movement | Signal | Explanation |
| Rising MA | Price closes above the MA | Uptrend | An exhausting downtrend lost its power over the market, changing the trend to uptrend. |
| Declining MA | Price closes below the MA | Downtrend | The buying pressure is about to run its course due to immense selling pressure. |
MAs are mainly based on historical price data, which makes them objective. However, treating MAs as an ultimate indicator or a self-confirming one is detrimental to your trading account.
Remember, you should always employ a multi-indicator analysis to ensure you’re staying atop the complex forex market.
Moving Averages Envelopes (MAE) addresses MA’s susceptibility to providing false signals. Utilizing this indicator avoids rapid whipsaw when the price trades differently from the provided signal.
At its core, MAE supplements MA with percentage-based bands - 5% higher and lower bands relative to the moving average. This way, an established trend should occur first before the provision of entry signal.
What makes Moving Average Envelopes different and more reliable than Moving Average is its component. Instead of having a smooth single line moving with the trend, MAE incorporates two more bands into the equation.
These two percent-based bands represent the two extremes of the market – the higher band represents the resistance level, while the lower band represents the support level.
When the price moves past either of the two extremes, a change in trend is confirmed.
The moving average is the basis point of the upper and lower bands (upper and lower envelopes)
Typically, a trader uses a Simple Moving Average (SMA) as a center band. This is because of its non-sensitivity to short-term price fluctuations.
The first step in getting the SMA of an asset price is by determining the period of analysis. In other words, figure the market timeframe you’d want to analyze.
Once decided, you then get the sum of all closing prices across the periods.
And then, divide the closing price sum by the number of selected periods.
SMA Formula:
(A1 + A2 + ... + An) / n
Whereas:
An represents price data of a specific period
n represents the selected total number of periods
Also known as the higher band, the upper envelope is a smooth level 5% higher than the moving average.
When you select MAE as your indicator, the chart will automatically plot this higher band. However, doing it yourself helps you better understand and interpret the prevailing market trend.
Upper Envelop Formula:
SMA x (1 + 0.05)
Whereas:
SMA represents the center band
0.05 represents the 5% price point difference between the center band and upper band
Conversely, the lower envelope is also known as the lower band. In other words, it’s the price level that’s 5% below the center band or the SMA.
Like the upper envelope, your trading chart will automatically plot the lower envelope when you select MAE as your chart indicator.
However, if you want to determine the asset’s lower MA envelope yourself, you can follow the formula below.
Lower Envelope Formula:
SMA x (1 – 0.05)
Whereas:
SMA represents the center band
1 – 0.05 represents the 5% distance between the center band and lower band.
Let us look at how Marie uses the MAE indicator to confirm market trends and identify profitable entry signals.
She planned on trading the EUR/USD; however, she’s unsure of the price's direction. Therefore, Marie implements MA in her trading strategy to spot and determine a profitable entry signal—whether a selling or buying signal.
What she does is to get the 200-period SMA of the EUR/USD.
However, she’s aware of the limitation of using moving averages alone—they’re susceptible to false signals.
To address this, Marie proceeded to use the moving average envelope indicator.
The usual moving average indicator suggests any changes in the trend direction. While it’s important for finding profitable entry points, it can be insufficient for providing fuller market perspectives.
When you use the moving average envelope, you’ll have a reference regarding the market condition – whether it’s overbought or oversold.
An overbought market represents an asset price above its intrinsic value. When this happens, the market is filled with long orders. However, since the price of an asset becomes unreasonably high (expensive), it will eventually fall back into its usual price range.
With MAE, you can identify an overbought market when the price trades above the upper envelope. Acting as a dynamic resistance level, the price will bounce back once it gets hit.
An oversold market represents a too-cheap asset price. This becomes attractive to traders, who enter the market and push the price up.
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