Similar to the RSI indicator and the Bollinger Bands®, this technical indicator aims to identify overbought and oversold conditions. It consists of two lines that are displayed over the price chart. The first line, usually of green color, is a moving average based on the high prices over a period of time, while the second line, usually red, is a moving average of a pair’s low prices over the same period of time. In addition, this indicator has a ‘deviation’ setting, which represents the percentage to be added to the high price average and subtracted from the low price average before plotting the lines on the chart.
The simple theory behind the Envelopes indicator is that prices constantly move between the upper and the lower lines, reversing when either band is reached. We interpret the price reaching the upper green line as an overbought condition signaling to sell the market. When price reaches the lower line, the Envelopes indicator signals a buy signal in an oversold market.
As with the Bollinger Bands®, especially when the market is trending, it is possible that the price does not reverse once it reaches oversold or overbought territory, choosing to slide for quite a while along the upper or lower indicator lines instead – see price falling below red line on left side of image, but not reversing direction. Therefore, it is recommended to first await confirmation of a reversal, or using a tight stop loss when entering a trade solely based on this indicator’s signals. Envelopes are best used in ranging markets.
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