If you are in search of a way to identify when an asset is overbought or oversold, you could try using the envelopes indicator.
In this guide, we will cover what envelopes are, how to plot them on your charts, and how you can use them as part of your trading strategies.
The envelopes indicator is a set of moving averages. When you plot them, you will notice that price often ranges between the two of them, but sometimes breaks above and below.
Key point: A pair of moving averages forms the envelopes indicator.
When you plot envelopes on your chart, you will need to choose:
What is the purpose of the percent? It has to do with sensitivity. If you are worried about fakeouts in volatile conditions, you should choose a higher percent. If, on the other hand, the market is not volatile and you are worried about not finding enough trade entries, a lower percent may be appropriate.
Here is an example of the calculations for an envelope. This one uses simple moving averages, a 10-day period, and 1%.
Maybe you want to change the percent to 5%, but keep everything else the same. Then you would use:
Perhaps you want to go with a 20-day SMA instead with 5%. Then you would use:
When you add the envelopes indicator to your chart, you put in the inputs you want, and the charting platform takes care of the math.
Also, note that some envelopes indicators seem to plot with a mid-point SMA, displaying three lines. Others seem to plot without the mid-point SMA, displaying two lines.
Key point: Although the computations for the envelopes indicator are relatively easy to understand, your charting platform it should take care of them for you once you select your inputs.
The pair of moving averages that comprises the envelope indicator shows us when conditions are overbought or oversold.
When you see the price of an asset pass the lower bound of the envelope, that suggests that the market is oversold, and that you should buy. The lower bound is showing you an area of support.
If, on the other hand, you see price pass the upper bound of the envelope, that suggests that conditions are overbought, and you should sell. The upper bound is showing you an area of resistance.
Something else you will notice about envelopes is that they can help you visualize trending and ranging markets.
When price is trending upward or downward, the moving averages comprising the envelopes will be doing the same thing.
When price is ranging sideways, you will likewise see the envelopes moving more or less sideways as well rather than strongly upward or downward.
Key point: By plotting envelopes on your chart, you can detect when an asset may be overbought or oversold. You also can visualize trending and ranging markets.
It is easy to plot envelopes. Here are the steps if you are using MetaTrader 4:
Key point: It takes just minutes to add envelopes to your Forex charts
You may see some confusing and seemingly contradictory instructions on how to use the envelopes indicator while you are trading. This is because context determines a lot about how you should interpret crosses above and below the boundaries of the envelope.
Because the two bounds represent potential overbought and oversold conditions, usually, you will use the envelopes indicator like this:
But there are exceptions when a new longer-term trend is forming.
Think about the way support and resistance behave in general. Usually, price bounces off of them, and they act as containment. But in some situations, when support or resistance are broken, price will continue to push onwards in a strong trend.
That applies when we are talking about envelopes as well. If you notice that price has broken one of the lines and does not appear to be bouncing back, it could mean that a trend is forming in that direction.
In such a situation, you would instead trade like this:
You can see how this could get to be confusing. We will talk a bit more about this in the section below.
Key point: Since the bounds of envelopes act as support and resistance, typically, we would take long positions when we see price closing below the bottom line, and short positions when we see price closing above the upper line. But in cases where support or resistance appears to have been truly broken by a strong trend up or down, we might trade instead in the direction of the trend.
Key point: Context, rules, and testing are essential to make good use of envelopes.
The envelopes indicator can help you identify overbought and oversold markets and to spot trends. Now you have a tool you can use to figure out when an asset may be overbought or oversold. As a bonus, it can also help you detect the formation of long and short trends that break outside of the levels of support and resistance it identifies. Use envelopes as part of a tested trading method to get the best results.
If you have any questions about the Envelopes indicator or if you just want to discuss its use in trading with others, you can proceed to our Forex forum.
If you want to get news of the most recent updates to our guides or anything else related to Forex trading, you can subscribe to our monthly newsletter.