If you observe the stock price movement in the market, you will find a pattern in it. The price movement isn’t ad-hoc, as most people would like to believe; instead, it moves within a range. Establishing the price range helps technical traders identify the extremely overbought and oversold situations. A range, made of two bands, upper and lower, is placed against the moving average line to create an envelope.
Therefore, a price envelope is a technical indicator typically placed in a price chart to identify the upper and lower bounds. A common example of an envelope is a moving average. In this blog, we are going to discuss what price envelope is in the trading strategy.
How Does A Price Envelope Work?
Traders use the bands commonly to identify a price range. It is drawn in such a way that 90 percent of price action takes place within the band. Traders adjust the band when volatility increases. The upper and the lower bounds respectively denote the upper and lower price limits of a stock. When a stock price touches the upper limit, it is called an overbought situation, prompting a sell signal. Conversely, when the price drops to the lower range, the situation changes to an overselling condition, triggering a buy signal. In normal conditions, the price roams within the range.
However, the price envelope isn’t self-reliant, meaning it needs to conform with other technical charts to validate a trend. Suppose you identified a trading opportunity when the price moves outside the range, so you check with the volume metrics to confirm the actual tipping point.
Traders use different percentages to identify unique price points. For volatile stocks, they will use a higher percentage to avoid whipsaw trading signals.
Price Envelope Example
A moving average (MA) is a common example, created using simple or exponential moving average lines. A common method uses 50 days simple moving average (SMA) to measure the upper and lower bounds. The formula they use is the following,
Upper bound = SMANx X [1 + D%]
lower bound= SMANx X [1 – D%]
Where N denotes the number of periods used for averaging, and D signifies deviation value.
Traders use price envelopes to take a long or short position in the market. For example, they will enter a short when the stock or ETF is selling above the upper bound.
Identifying Trading Signals Using Price Envelope
While studying the price envelope, here are a few things to keep in mind.
- The stock price moves back and forth across moving average lines. The action is called ranging
- When the price moves above the upper limit, it signifies an up-trend
- When price travels below the lower band, it indicates a downtrend
When price travels above or below the ranges, it stays in that area for some time, creating trading opportunities, though it is not always a reliable theory to follow. So to be safe, place your stop-loss just above or below the upper and lower bounds, respectively.
When trading along the trend line, the rule of thumb of using price envelope suggests – (a) opening a position when the price moves below the lower band and (b) going short when price moves above the upper limit.
An uptrend occurs when price moves between the upper band and the MA line in the trend market. Similarly, a downtrend happens when price stays below the MA line but above the lower price band. Go short when the price rallies along with the downtrend and exit the market when the price crosses below the lower band or above the moving average line. Simultaneously, while taking a position in a downtrend, place the stop-loss above the most recent high. Conversely, you will have to reverse your position when going long in the uptrend.
A price envelope is a critical tool in your trading strategy. It smooths out the noise and let you see the broader pattern in the market. When the moving average line is moving upward, it signals an uptrend. With a price band in place, we can confirm the direction the trend is shifting. If the bands too are moving upward, it establishes an uptrend. The price envelope offers a visual representation to traders to discover the exact point where market sentiment is turning.