The moving average envelope is a variant application to the moving
average. It is a trading band composed of two moving averages, which
attempts to determine the range of market should be trading in. Traders
can choose their period of MA, then form the upper line of the envelope
by shifting the MA upwards and the lower line of the envelope by
shifting the MA downwards.
The reasoning behind the envelope is that moving averages define the general trend of the market and are the best-fit line to the recent movement of the price. Most of the data should appear close to the moving average lines. The envelopes define a range away from the moving average that the price should return to the center in a short term if the price strays too far away from the moving average. Therefore, the envelopes are best to identify potential reversals when the price hits the envelope boundaries.
On a daily chart, it is common to use 21-day Simple Moving Average and form the envelopes with 2% or 3% above and below the 21 day SMA. For longer term trading, traders can choose longer time frame like 50-day SMA and larger percentage variation like 5%.
In the above chart, you can see prices stay within the 3% band most
of the time. When the price hits the boundary of the envelopes, it is a
sign of reversal. Somehow the price returned to the centerline and move
on again. However, traders are reminded that not every signal is valid.
When the trend is strong enough, it can raise (or fall) along the
envelope boundary resulting many false signals.
MACD
Moving Average Convergence Divergence (MACD) shows the difference of two moving averages - EMA12 and EMA26, and a 9-day EMA of the difference is plotted against it to trigger buy or sell signal.
There are three parameters in MACD:
When the MACD line is far above from the centerline, the market is considered to be in overbought condition; while the MACD line is far below the centerline, the market is deemed to be in oversold condition.
2. Crossovers
When the MACD line crosses above the signal line, a buying signal is generated; while the MACD line crosses below the signal line, a selling signal is generated.
3. Divergences
If the price is moving higher, but the MACD line is moving lower, it signals the weakening of the up-trend or a reversal. If the price is moving lower, but the MACD line is moving higher, it signals the weakening of the downtrend or a reversal.
The reasoning behind the envelope is that moving averages define the general trend of the market and are the best-fit line to the recent movement of the price. Most of the data should appear close to the moving average lines. The envelopes define a range away from the moving average that the price should return to the center in a short term if the price strays too far away from the moving average. Therefore, the envelopes are best to identify potential reversals when the price hits the envelope boundaries.
On a daily chart, it is common to use 21-day Simple Moving Average and form the envelopes with 2% or 3% above and below the 21 day SMA. For longer term trading, traders can choose longer time frame like 50-day SMA and larger percentage variation like 5%.
MACD
Moving Average Convergence Divergence (MACD) shows the difference of two moving averages - EMA12 and EMA26, and a 9-day EMA of the difference is plotted against it to trigger buy or sell signal.
There are three parameters in MACD:
- MACD line - the difference between the 12 and 26 period EMA
- Signal line - the 9 day EMA of the MACD line
- Histogram - a visual representation of the difference between the MACD line and the signal line
Applications of MACD:
1. Detect overbought/oversold levelsWhen the MACD line is far above from the centerline, the market is considered to be in overbought condition; while the MACD line is far below the centerline, the market is deemed to be in oversold condition.
When the MACD line crosses above the signal line, a buying signal is generated; while the MACD line crosses below the signal line, a selling signal is generated.
If the price is moving higher, but the MACD line is moving lower, it signals the weakening of the up-trend or a reversal. If the price is moving lower, but the MACD line is moving higher, it signals the weakening of the downtrend or a reversal.
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