Envelope

What Is an Envelope?

Envelopes are technical indicators that are typically plotted over a price chart with upper and lower bounds. The most common example of an envelope is a moving average envelope, which is created using two moving averages that define upper and lower price range levels.

Envelopes are commonly used to help traders and investors identify extreme overbought and oversold conditions as well as trading ranges.

Key Takeaways

• An envelope, in technical analysis, refers to trend lines plotted both above and below the current price.
• An envelope's upper and lower bands are typically generated by a simple moving average and a pre-determined distance above and below the moving average—but can be created using any number of other techniques.
• Many traders react to a sell signal when the price reaches or crosses the upper band and a buy signal when the price reaches or crosses the lower band of an envelope channel.

How Envelopes Work

Traders can interpret envelopes in many different ways, but most use them to define trading ranges. When the price reaches the upper bound, the security is considered overbought, and a sell signal is generated. Conversely, when the price reaches the lower bound, the security is considered oversold, and a buy signal is generated. These strategies are based on mean reversion principles.

The upper and lower bounds are typically defined such that the price tends to stay within the upper and lower thresholds during normal conditions. For a volatile security, traders may use higher percentages when creating the envelope to avoid whipsaw trading signals. Meanwhile, less volatile securities may necessitate lower percentages to create a sufficient number of trading signals.

Envelopes are commonly used in conjunction with other forms of technical analysis to enhance the odds of success. For example, traders may identify potential opportunities when the price moves outside of the envelope and then look at chart patterns or volume metrics to identify when a tipping point is about to occur. After all, securities can trade at overbought or oversold conditions for a prolonged period of time.