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While moving averages are a useful tool to have in your technical analysis toolbox,
they can be susceptible to providing false signals.
Like you’ve learned in previous lessons on moving averages, a simple buy signal
occurs when prices close above the moving average.
And a simple sell signal occurs when the price closes below the moving average.
For example, let’s say EUR/USD is moving upward and closes above a moving
average, signaling an entry to go long.
How do you know that this bullish trend is “real” and will continue?
You don’t.
1. Go long now based on the original entry signal (price closed above MA)
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Like this?
One line is ABOVE the moving average and the other line is BELOW the moving
average.
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It’s called an envelope (noun) because these two lines envelope (verb) the original
moving average line.
• Confirm trend
Lastly, set the percentage value you’d like to use for the envelopes.
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For example, a 10-day moving average with a 1% envelope would show the following
lines:
Notice how the envelopes (blue lines) move parallel with the 10-day SMA (orange
line).
They remain a constant 1% above and below the moving average (orange line).
When the envelopes are moving sideways, the price is neither in an uptrend or
downtrend. The trend is neutral and the price is considered directionless.
You should pay attention when the price moves above or below the envelopes.
Since trends often begin with a strong move, if the price surges above the upper
envelope, this is considered bullish.
If the price plunges below the lower envelope, this is considered bearish.
Buy Signal
Sell Signal
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Example: GBP/USD
In the chart below, notice how the 20-day simple moving average (orange line) and the
upper and lower envelopes (blue lines) are moving higher.
See how the price managed to close above the moving average?
To confirm that the trend has changed from bearish to bullish, you could wait until the
price has also closed above the upper envelope.
When the price moves below the lower envelope, this can be considered oversold.
Remember, a currency pair can become overbought and remain overbought when the
bullish trend is strong.
The same goes for being oversold. In a strong bearish trend, something can be
technically oversold, but remain oversold for quite some time.
This is why it’s best to pay attention to the slope of the moving average and make
sure it’s flat.
You should confirm overbought and oversold levels with support and resistance levels.
Buy Signal
If price touches or falls beneath the LOWER envelope, then rises back above, buy.
Sell Signal
If price touches or rises above the UPPER envelope, then falls back below, sell.
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Example: EUR/JPY
In the chart below, notice how the 30 SMA (orange line) and the upper and lower
envelopes (blue lines) are flat…almost horizontal even.
EUR/JPY is directionless here. There is no strong bullish trend, nor is there a strong
bearish trend.
Whenever price traded near the upper envelope, the price would fall back down.
The same with the lower envelope. Observe how it acts as a strong support level.
Whenever price traded near the lower envelope, the price would bounce back up.
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Summary
Moving average envelopes (MAE) are used as a tool to confirm trend direction, but
can also be used in sideways markets to identify overbought and oversold levels.