Generating Signals

Trading Range:

Envelopes can be used during trading ranges as they will tell a trader when the currency is overbought or oversold within that range. Figure 2 is a blow up of the right part of the Figure 1 from the previous page, this time with a 21 period moving average and a 1.5% MA envelope. Once a trading range is identified, in the beginning of February, a trader could have interpreted several buy and sell signals from the moving average envelopes that would have been correct.

1. When the price touches the upper boundary it is a good indication that the currency (here the US Dollar) is overbought. If the price turns back down after touching the upper bound, as it does in this case, then a trader should sell the Dollar, or go short.
   
   • The upper boundary is breached earlier than the Sell signal drawn in the figure. Automatically selling as soon as price reached the boundary, at the beginning of February, would be a negative trade as price turns up and "rides up the boundary" before clearly reversing. (See the commentary on "riding a boundary (pg 5)" in our Bollinger Bands article. Clicking on these links will open the pages in a new window.)
2. If the cycle continues then a trader should close his short position when the price hits the lower boundary. Once the price starts edging up after touching this lower boundary, the trader should buy the Dollar, or go long, in the anticipation of the price rising.
3. At point 3, price again approaches the upper boundary. Even though price doesn't hit the envelope lines, price turns back at the 118.90 level. This price level acted as resistance in February. Price starts reversing, and if the trader speculates that ranging market conditions will continue, he should close his long position and sell, similar to point (1).
4. The currency pair keeps within its trading range and this signal is the same as in step (2).

Traders Time Horizons

This technique is more appropriate for short term investors as they are best positioned to take advantages of these cyclical changes. The technique stops working if the currency breaks out of its trading range and begins a new trend. In the first half of the above figure, even though price touches the lower boundary, it would be very inopportune to buy there as the price keeps going down and makes new lows (and the trader would incur a loss).

To avoid getting losses when using this technique a trader should place stop losses at the previous low when buying or going long (2 & 4), and at the previous high when selling or taking a short position (1 & 3).

Trending Signals

For instances when the currency is trending, the moving average envelopes generate signals in a very different way. A trader would use prices penetrating the upper boundary to initiate long position because this can be an indication that the trend is strong and prices will continue rising. If prices penetrate the lower boundary it can be taken as a signal to initiate short positions. The reliability of using this technique is very poor and can give many false signals. The envelope’s breaches may be used as a way to identify the strength of new trends, and to identify them in general, but should not be used as actual buy and sell signals.

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