The envelope channel tool points to price reversals and is built around two separate moving averages that are a specific percentage away from a moving average of price.
The envelope tool creates top and bottom levels and traders often look to the areas outside of the band they define for signs of overbuying and underselling in the market.
It’s usually placed over a price chart, so you get a convenient view of where the present price stands in comparison. When the price is within the bands this is called a “normalized area”. You’ll take it as a trade signal if it goes outside.
It’s up to you how you interpret a move like this. It comes down to personal preference. If price heads out above the top band, some will take this as a breakout and a signal to maybe go long. Others might see this as a sign of overbuying or a signal that the price is stretched and so they’d be looking to sell/go short.
The Envelope Channel Calculation
For the envelope channel, it’s a matter of calculating two or three moving averages (according to how many bands you want to work with) that are plus or minus n% away from a moving price average.
For a simple moving average, it takes the average of a defined number of previous price bars. You can also adjust them to the exponential and front weighted variants as well, and this gives more credence to recent data.
It works at the top and bottom bands using high and low price values respectively from a defined number of previous price bars.
The user can adjust the high and low bands up or down using a selected percentage as they wish. If you decide to have a middle band there’s no need to do this because it’s just a simple moving average of price.
You can specify how many previous price bars you want to use, but most charting software that uses this indicator will be set to a 50-period already.
With some of them you’ll be able to adjust the envelope channel by feeding in the number of standard deviations (and the bigger the number, the wider the bands, the lower the number, the narrower). However, this isn’t accurate. Envelope channels shift the bands by a certain percentage. If they did use standard deviation, then they would be the same as Bollinger bands. While they are similar indicators, they are underpinned by different concepts.
Irrespective of this, you can set up the envelope channel in whatever way suits you best.
What You Can use the Envelope Channel For
The envelope channel is usually used as a price reversal indicator in tandem with Bollinger bands. These are worked out using the standard deviation of a moving average. The envelope channel uses a moving average of +n% and –n% away from the mean. This means that it won’t respond so well to a volatile market, but it will give a range that follows price and is more in keeping with a true channel or fixed range.
If the middle band is plotted, it’s the same between the Bollinger bands and envelope channel.
Bollinger bands are usually pressed into service as a trend-following indicator and when price moves beyond the bands this points to a breakout move going that way. The tool also makes a good visual guide for gauging how volatile things are looking. Wide bands mean ‘very volatile’ and narrow bands mean ‘not so much’.
The envelope channel does a better job of highlighting the potential reversal and price. If you set the percentage deviation from the mean high enough then of course you won’t see price moving beyond that range very often.
Also, when it looks like rapid price moves are going to shift price outside of the channel the effect is blunted. Markets might just be reacting knee-jerk fashion to the news cycle and such rapid moves will be short lived and probably reversed. There are always exceptions to this of course, especially when some new information comes to light that has a drastic impact on pricing, but even these adjustments won’t last forever. This difference between them becomes even more obvious as the market experiences more volatility.
So, you can interpret the envelope channel however you wish, but the usual way of thinking is that when price touches that top band it’s a signal of over buying so you’d want to sell. And a touch of the bottom band means ‘oversold’ so it’s time to buy.
Since there’s a good chance that price will stay inside the band for a predictable block of time, you could see it as legitimizing the idea that any excursions beyond its boundaries might be a signal of an impending price reversal.
Of course, how wide the envelope is has a bearing on this. When the parameters are wide then the price will usually stay within them for longer. They’ll produce fewer but more accurate signals because there’s a lower chance of them leaving the band to start with. As a trader it’s your call on finding the right balance between the two.
Conclusion
The envelope channel is a price reversal indicator that helps you to find when price is becoming stretched. Setting wider bands gives greater reliability of signals but you’ll get fewer of them. So, it’s best to err on the side of caution with wider bands, rather than risk being overwhelmed by a torrent of false positives.
You can apply the envelope channel to any period of time, but you’ll need to tweak the settings to suit that period and whatever asset you’re looking at. If it’s a volatile one and the timeframe is higher then you’ll need a wider channel to get better signals of price reversals.
For instance, if you’re trading off the hourly chart and you’ll be holding positions for just days instead of weeks or longer, reduce the width of the envelope channel proportionately in relation to how it would look if you were using the daily chart.
Similarly, when you’re going off a weekly chart, use a wider band than someone would if they were trading with a shorter timeframe. The size of the adjustment will depend on the market and don’t forget to backtest it to confirm that it at least works with historical signals.
