MA Envelopes Refining A Popular Trading Tool

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. (For background reading on this reliable and useful indicator, see our Moving Averages tutorial.)

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. (Learning to analyze charts can be a big help when making trading decisions. Check out the Analyzing Chart Patterns tutorial to learn how.)
Simple buy signals occur when prices close above the moving average; sell signals occur when prices fall below the moving average. This idea is illustrated in Figure 1. The large arrows show winning trades, while the smaller arrows show losing trades, when trading costs are considered.

Drawbacks of Envelopes
The 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. (For related reading, see Patience Is A Trader's Virtue.)

In theory, moving-average envelopes work by not showing the buy or sell signal until the trend is established. Analysts reasoned that requiring a close of 5% above the moving average before going long should prevent the rapid whipsaw trades that are prone to losses. In practice, what they did was raise the whipsaw line; as it it turned out, there were just as many whipsaws, but they occurred at different price levels. (Learn how a change in market direction can be your ticket to big returns in Turnaround Stocks: U-Turn To High Returns.)
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 Better
The 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. (For more on identifying market trends, read Short-, Intermediate- and Long-Term Trends.)

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. (Read about the importance of the stop-loss order in The Stop-Loss Order: Make Sure You Use It.)