Moving averages (MA) are a popular trading tool. Unfortunately, they are prone to giving false signals in choppy markets. By applying an envelope to the moving average, some of these whipsaw trades can be avoided, and traders can increase their profits.

What Is an Envelope?Moving averages are among the easiest-to-use tools available to market technicians. A simple moving average is calculated by adding the closing prices of a stock over a specified number of time periods, usually days or weeks. As an example, a 10-day simple moving average is calculated by adding the closing prices over the last 10 days and dividing the total by 10. The process is repeated the next day, using only the most recent 10 days of data. The daily values are joined together to create a data series, which can be graphed on a price chart. This technique is used to smooth the data and identify the underlying price trend.

Figure 1: Source: TradeNavigatorThe monthly chart of Starbucks shows that a simple moving average crossover system would have caught the big trends.

Drawbacks of EnvelopesThe problem with relying on moving averages to define trading signals is easy to spot in Figure 1. While the winning trade shown in that chart was very large, there were five trades that led to small gains or losses over a five-year period. It is doubtful that many traders would have the discipline to stick with the system to enjoy the big winners.

To limit the number of whipsaw trades, some technicians proposed adding a filter to the moving average. They added lines that were a certain amount above and below the moving average to form envelopes. Trades would only be taken when prices moved through these filter lines, which were called envelopes because they enveloped the original moving average line. The strategy of placing the lines 5% above and below the moving average to form an envelope is illustrated in Figure 2.

Figure 2: Source: TradeNavigatorAdding lines 5% above and below the moving average forms moving-average envelopes.

Another drawback to using envelopes in this way is that it delays the entry on winning trades and gives back more profits on losing trades.

Making Envelopes Work BetterThe goal of using moving averages or moving-average envelopes is to identify trend changes. Often, the trends are large enough to offset the losses incurred by the whipsaw trades, which makes this a useful trading tool for those willing to accept a low percentage of profitable trades.

However, astute market observers noticed another use for the envelopes. In Figure 3, we show a weekly chart of Starbucks with a 20-week moving average and envelopes set 20% above and below the moving average. Most of the time, when prices touch the envelope lines, prices reverse. But there are some times when they continue trending, leading to losses.

Figure 3: Source: TradeNavigatorWider envelopes are useful for spotting short-term trend reversals.

Among the earliest proponents of this countertrend strategy was Chester Keltner. In his 1960 book, “How to Make Money in Commodities”, he defined the idea of Keltner bands and used slightly more complex calculations. Instead of using the close to find his moving average, he used the typical price, which is defined as the average of the high, low and close. Instead of drawing fixed-percentage envelopes, Keltner varied the width of the envelope by setting it to a 10-day simple moving average of the daily range (which is the high minus the low). This method is illustrated in Figure 4.

Figure 4: Source: TradeNavigatorKeltner bands contain most of the price action, and short-term traders may find them useful as a countertrend system.

Buy signals are generated when prices touch the lower band, represented by the green line in Figure 4. While Keltner bands are an improvement over the set-percentage moving-average envelope, large losses are still possible. As can be seen on the right side of the chart, the last time prices touched the lower envelope in this chart, they continued to fall. A simple stop-loss would prevent losses from growing too large and make Keltner bands, or a simpler moving-average envelope, a tradable system with profit potential for traders on all time frames

Later, John Bollinger built upon the idea of moving-average envelopes and Keltner bands to develop Bollinger Bands, which enveloped a simple moving average with lines two standard deviations above and below the moving average. This is a mathematically precise way of implementing envelopes to achieve a high number of winning trades because Bollinger Bands are designed to contain 95% of the price action.

In SummaryMoving-average envelopes offer a useful tool for spotting trends after they develop. More precise tools based on the same idea, like Keltner bands or Bollinger Bands are useful for identifying high-probability turning points in short-term trends. All traders can benefit from experimenting with these technical tools

Michael Carr can be contacted at Dunn Warren Investment Advisors