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How to Use the Envelope Indicator to Identify Overbought and Oversold Levels

Envelope indicator: Technical analysis tool for identifying overbought and oversold levels and predicting trend reversals.


Welcome, everybody. Financial markets always attract the interest of millions of people worldwide. These markets include stocks, currency pairs, commodities, and many other financial instruments. While these markets are full of opportunities, one must not overlook the risks. To succeed in the financial markets, the ability to forecast market movements is indispensable. For this purpose, we need to combine technical and fundamental analysis. Fundamental analysis is an investment tool that uses economic, financial, and sectoral data to determine the true value of an asset. It is particularly important for long-term investors because market prices are more likely to move based on fundamental factors. Financial markets are often characterized by fast and complex price movements. Understanding these movements and making the right decisions is very important  for our success. This is where technical analysis tools and indicators come into play. The Envelope indicator is one of these indicators. In this article, we aim to explain the basics and usage of the Envelope indicator, providing an understanding of how to interpret this indicator.

What is the Envelopes indicator?

The Envelope indicator is a type of oscillator in technical analysis. It measures how price movements change between bands and indicates how close the market is to overbought or oversold conditions. This indicator is used to track the price movements of a financial instrument and to determine possible support and resistance levels. Besides that, the Envelope indicator helps identify points where market prices have peaked at overbought and oversold levels and are likely to reverse. The Envelope indicator draws boundaries around price movements, signaling probable points where market trends may change direction. In other words, it provides signals used to identify price retracements and probable trend reversals.

Components and calculation of the Envelope indicator?

The Envelope indicator measures the deviation of prices from a moving average. To visualize these deviations, the Envelope indicator draws two lines or bands around the moving average:

1. Upper Band: The upper band is typically a line that represents price movements being a certain percentage above a moving average. For instance, if we are using a 5% upper band, it means the line will be located 5% above the moving average. The Envelope indicator has a simple formula to calculate the Upper Band:

    Upper Band = Moving Average + (Moving Average x Chosen Percentage)

2. Lower Band: The lower band represents price movements being a certain percentage below a moving average, just like the upper band. The same percentage is used for both upper and lower bands. The formula is as follows:

    Lower Band = Moving Average - (Moving Average x Chosen Percentage)

In this context, the Upper Band represents the upper boundary of the Envelopes indicator. The Moving Average is usually calculated as the average of closing prices over the chosen period. The Chosen Percentage determines how far apart the upper and lower bands will be from the moving average. For example, if we use 5%, it indicates that the upper and lower bands will be 5% away from the moving average.

In the chart below, with a 20-day moving average and a chosen percentage of 5%, the formula will be as follows:

  • Upper Band = 20-Day MA + (20-Day MA x 0.05)
  • Lower Band = 20-Day MA - (20-Day MA x 0.05)

The Envelope indicator illustrates that prices move within a specific range around the moving average. This information enables us to analyze price movements and create our own trading strategies.

Trading with the Envelope indicator

The Envelope indicator is a technical analysis tool based on Moving Averages (MA). This indicator is used to track price movements in financial markets and identify trends. Like other Moving Averages, the Envelope indicator has specific characteristics and applications. Firstly, the slope of the indicator lines indicates the direction of a trend. If the Envelope bands slope upward, it can signal an uptrend. Conversely, if the bands slope downward, it indicates a downtrend. These slopes help us define the market trend. When the market is in a specific range, price increases above the upper Envelope band suggest that the asset is overbought and likely to reverse. On the contrary, movements below the lower band indicate that the market is oversold, and the price may reverse. In these situations, we can consider entering trades to capture reversals. In the first scenario, we might enter a Sell order, and in the second, a Buy order. Take a look at the example on the weekly AUD/NZD chart below:

Envelope indicators are a powerful tool that can be used to identify market trends and to make predictions about future price movements.
Trading with Envelope Indicator on AUD/NZD chart

The envelope bands create a channel where the price moves. It's recommended to buy when the price reaches the lower band during an uptrend and to sell when the price reaches the upper band during a downtrend. These trades are made with the expectation that the trend will continue. The lower and upper bands act as support and resistance levels.

Remember. In the world of trading, risk management is a critical component of any trading strategy. While it's important to predict market movements and generate trading signals using indicators like the Envelope indicator or other analysis tools, it's not possible to guarantee the success of every trade based on these signals. Every trading decision involves risk. Therefore, even when using the Envelope indicator or other analysis tools, it's essential to develop strategies for managing risk to minimize probable losses. Best of luck in your trading!

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