Trading Regime Analysis: The Probability of Volatility

By Murray Gunn
Copyright © 2009 John Wiley & Sons Ltd.

9
Moving Average Envelopes

The humble moving average is probably one of the most useful indicators in market
analysis. Moving averages can determine trend direction but they can also be used as
an overbought, oversold oscillator if we measure extreme readings away from them.
They are the backbone of technical market analysis and appear in some form or
another in most methods and indicators. Look, even economists use them! I always
like to rib economists that they are actually trend followers in disguise because
what they tend to do is to look at a chart of some economic data – for example,
retail sales – and, in order to filter out the “noise” in the series, they put a mov-
ing average on it to determine the underlying trend. This is what economists do.
They try to determine the trends in the economy in order to predict the future
course of market price action (however disputable that may be) but, in order to
determine the trend direction, they look at a moving average of an economic data
series and then assume that this trend will continue into the future! Exactly as
trend followers of market price data do. In methodology there is little difference
between an economist and a trend follower, but in ideology there is, of course,
a massive gap as the economist assumes that by identifying the trend of some eco-
nomic variables – which may or may not be correlated to the market price – he
can determine the future course of market prices, whereas the trend follower iden-
tifies the trend of the market price itself and follows that and that alone. Therefore,
the moving average can be thought of as one of the pillars of all market analyses.
Ironically enough there is a very valid argument for saying that economists should
not really be looking at moving averages on their macro-economic data but should
instead be using oscillators to identify when something is overbought or oversold,
because the long-term macro-economic data will tend to move in cycles (the business
cycle), and although moving averages will pick up a lot of the trend from over-
bought to oversold and vice versa they will lag many of the inevitable turns in the
cycle. Nevertheless, the moving average remains the most popular of all statistical
techniques.
180 Trading Regime Analysis

Besides looking at moving averages for trend direction and trend extremities we
can also look at moving averages to help us to identify the market’s trading regime.
This is done through a technique known as moving average envelopes (MAEs).
The concept of moving average envelopes is simple. All we do is take a moving
average of the market price and plot a line a fixed percentage above the moving
average and plot another line a fixed percentage below the moving average. In this
sense we have, around a moving average, created bands that form an “envelope”
around the market price action.
Figure 9.1 shows the bar chart of the EURUSD exchange rate in the daily time
fractal with moving average envelopes. The dashed line is the 21-day moving average
and the solid lines are plotted at 1% above and 1% below this moving average. We
can see that sometimes the price action trades inside these envelopes and sometimes
the price action trades outside these envelopes.

1.43 1.43

1.41 1.41

1.39 1.39

1.37 1.37

1.35 1.35

1.33 1.33

1.31 1.31

1.29 1.29
Source: Bloomberg L.P.
1.27 1.27
09/1/2007 20/3/2007 29/5/2007 07/8/2007 16/10/2007

Figure 9.1 EURUSD daily – moving average envelopes

This is where it gets interesting. Most people think of moving average envelopes
as indicators that will point out support and resistance areas. The theory is that the
lower envelope should provide support for the market price and the upper envelope
should provide resistance for the market price. The logic of this is flawed, I believe,
because it assumes that a market’s price action will be constrained by some fixed
percentage above and below a moving average. Now, I do believe that analysing the
distance that the actual market price is away from a moving average can provide a
good overbought or oversold oscillator indicator similar to the analogy of stretching
a rubber band – at some point it has to get to the point of maximum stretch. How-
ever, the notion that a market’s price action will be constrained by areas at a fixed
Moving Average Envelopes 181

percentage away from a moving average assumes that the market in question will be
going sideways most of the time, and this is clearly not the case in most markets. We
can see in Figure 9.1 that there are times when the market price clearly trades above
the upper band for a long period of time.
I prefer to use moving average envelopes as trading regime indicators by exam-
ining when the market is trading inside or outside the bands. If the market is trading
inside the bands, then we can say that the price action is being contained at that
time within a band of prices above and below the moving average. Therefore, in all
probability this will result in a choppy, range-trading type of price action. However,
if the market is trading outside the bands then we can say that the price action is not
being contained within a band of prices above and below the moving average and
therefore, in all probability, the market price action is behaving in a strong trending
fashion. In this way the moving average envelopes become an indicator of trading
regime and can be incorporated into an overall analysis of trading conditions.
Now there are certain issues with this indicator that have to be addressed. The
first is the usual issue with regard to what length of moving average to use. As
I have mentioned previously, I am not a believer in optimising variables like moving
averages but instead look to select a moving average on the basis of common sense
of what I am trying to achieve. In using moving average envelopes the goal is to
determine when the market is in a trending phase and when the market is in a range-
trading phase; therefore, in order for me, as a trader, to benefit from the analysis,
I do not want to have too short a moving average that will be chopped around with
the market price data, nor do I want too long a moving average that will hardly move
with the market price data. I want something in between that will capture the market’s
price cycles without being too sensitive or insensitive. By selecting a moving aver-
age on the basis of common sense I might not be selecting the moving average
that has the best “fit” to past data but I can rest assured that my logic of selection
is sound.
The second issue to address is the level at which we want the fixed percentages to
be above and below the moving average. Again, common sense has to be our guiding
light and it generally boils down to the time fractal the analyst is dealing with. If
the analyst wants to analyse trading regimes at the micro level or the very short
term, then because price fluctuations will be lower than they would be in the longer
term a smaller fixed percentage should be used. Conversely, if the analyst wants
to analyse trading regimes at the macro level or the very long term, then because
price fluctuations will be larger than they would be in the shorter term a higher fixed
percentage should be used.
Figure 9.2 shows the bar chart of the EURUSD exchange rate in the weekly time
fractal and moving average envelopes of 1% either side of a 21-week moving aver-
age. We can see instantly when comparing this chart to Figure 9.1 – which shows
the same moving average envelope variables but in the daily time fractal – that the
band on the weekly chart appears much narrower than on the daily chart. This is
because the price data in the weekly chart will have greater fluctuations (bigger bars)
182 Trading Regime Analysis

1.42 1.42

1.37 1.37

1.32 1.32

1.27 1.27

1.22 1.22

1.17 1.17

1.12 1.12
Source: Bloomberg L.P.
1.07 1.07
12/12/2003 26/11/2004 11/11/2005 27/10/2006 12/10/2007

Figure 9.2 EURUSD weekly – moving average envelopes

than those in the daily chart and, of course, this is a function of the time fractals.
A monthly chart would show even greater fluctuations.
Therefore, the trading regime analyst has to consider the time fractal and change
the fixed percentages of the envelopes accordingly. For longer time fractals the ana-
lyst will want to use bigger percentages to find sensible cycles in the market with
respect to regime, and for shorter time fractals the analyst will want to use smaller
percentages to find sensible cycles in the market with respect to regime. The ana-
lysts will also want to consider the type of market he is dealing with. As individual
stocks will fluctuate in percentage terms much more than currencies, the former will
generally have bigger fixed percentage bands than the latter.
The reader will observe that there are obviously times when the market price will
blip above the bands only to return to trading inside the bands, and there will also
be times when the market price can trend in a certain fashion while still being con-
tained within the bands. Nothing is going to be perfect, however, so we shouldn’t get
too bothered about this. Remember, what we are doing as trading regime analysts is
looking for situations where the probabilities favour a trend or where the probabil-
ities favour a range. In all market analysis we deal with probabilities and we never
deal with certainties, because there are none. Chapter 22 deals with how best to use
trading regime analysis, and that discussion deals with combining our trading regime
indicators in order to maximise this subjective analysis of probability.
Moving average envelopes allow us to see what trading regime the market is cur-
rently in and so it is not predictive. However, as with most, if not all, market analysis
the inference is that there will be a degree of persistence involved after an observation
is made. Borrowing again from our friend Keynes, the evidence is presented to the
analyst of market price or trading regime and, until the facts change, the assump-
tion must be that the recent past will continue. If evidence is presented that disputes
Moving Average Envelopes 183

this (a break above the moving average envelopes for example) then the facts of the
case have changed and the “view” of the analyst should change too.
Figure 9.3 shows the bar chart of the Nasdaq Composite Index and the associ-
ated moving average envelopes from 1995 until 2007 using the monthly time fractal.
We can see that the envelopes do a good job of defining when the market is in a
strong trend, either up or down, and when it is in a weak, sideways, choppy trend
such as in the move up from 2004. The market was making higher highs and higher
lows during that period and so the strict definition of an uptrend was there, but the
trend was incredibly weak and choppy. Trend-following systems would have really
struggled to make any sort of return during this period but, if the risk capital allocated
to such systems was altered to reflect the fact that the moving average envelope ana-
lysis suggested that a range-trading regime was most likely in force, the draw downs
could, in the very least, have been minimised. In fact, capital could also have been
allocated towards mean-reverting type systems and that would have enhanced returns
during this period.

4500 4500

3500 3500

2500 2500

1500 1500

Source: Bloomberg L.P.

500 500
28/4/1995 31/10/1997 28/4/2000 31/10/2002 29/4/2005 31/10/2007

Figure 9.3 Nasdaq Composite Index – moving average envelopes

VARIATIONS

There are many variations of the moving average envelope technique and one of them
came from Chicago grain trader Chester Keltner (1909–1998). He was a commodity
trader who, in 1960, wrote a book called How To Make Money In Commodities in
which he described “the ten day moving average trading rule” that subsequently
became known as Keltner Channels. It is, as the name suggests, a variation of the
moving average envelope showing a central moving average line plus channel lines
184 Trading Regime Analysis

at a distance above and below. Keltner’s centre-line is a 10-period simple moving

average of the “typical price”, which is the average of the high, low and close.
The upper and lower lines are calculated by the distance away from the centre-line
of the simple moving average of the past 10 periods’ trading ranges (high to low).
Keltner’s use of the indicator was to regard a close above the upper line as strongly
bullish and a close below the lower line as strongly bearish, so in this regard he was
using it as a non-continuous trend-following, volatility breakout type of system. He
did also stress, like most good analysts should, that other indicators should be used
to confirm the breakout.
There have actually been many variations of “channel” type indicators and systems
over the decades, but the key thing they all have in common is that trading within
the bands is considered to be noise/range trading and trading outside the bands is
considered to be breakouts/trends.

SUMMARY

This chapter has focused on using the humble moving average as a trading regime
indicator by plotting shadow lines at a certain percentage above and below the
moving average. We have used the methodology in a standard trend-following man-
ner in that we use the breaking of the envelopes as signals that the market price could
be about to enter a strong trending regime and only when the price is in between the
envelopes do we assume that a range-trading regime is in existence. This methodol-
ogy means that only when the market is in a strong trend will the regime be identified
as a trending regime, and if the market is trending in a weak manner it will not be
identified as a trending regime. In this sense it can be thought of as a channel or
volatility breakout method of analysis.
Using price envelopes or bands at a fixed percentage around a moving average
allow the trading regime analyst to define when a trend is strong or weak and, hence,
define the probability of the trading regime. Bands around a moving average, how-
ever, need not be fixed and can be variable. In the next chapter we will explore how
these variable bands can add a slightly different dimension to volatility analysis.