Technically Speaking: Moving average envelope reveals the major trend trading signals

Friday 26th January 2001

Coles Myer

Fairfax Holdings

Goodman Fielder

Macquarie Bank

Moving averages are a common method of representing a price trend underlying market data. Averages can be sophisticated in various ways.

The technique shown in the charts this week is called the moving average envelope. Four Australian stocks have been chosen at random and graphed as weekly data.

The parallel curves plotted over share prices are envelopes. The envelope bandlines track the base moving average (not shown in the charts) from which they are calculated. The average used as the base is 40 weeks.

The 40-week moving average is popular with technical analysts. For some reason it usually gives good representation of a share price's trend and fairly reliable crossover signals for trading purposes.

Each envelope stands at a distance of 10% of the value of the moving average either way. The upper band is the 40-week average plus 10%. The lower band is the average minus 10%.

Much price data is contained between the paired envelope lines. However, there are periods when price tracks outside the envelope.

Trading signals of various sorts can be derived from the envelope lines. For example, if the price moves up from the lower (-10%) band, it can be taken that an upturn in trend is under way and that the share is a potential buy.

If the price drifts down from the upper (+10%) band, it can be assumed that a downtrend has set in and that selling is desirable.

Where the price tracks outside the envelope, other trading signals can be inferred. For example, if the price is charting beneath the lower band, the inference is that the share is oversold. The trader would look for evidence that the price had crossed back above the -10% line to guess that the downtrend had decelerated or perhaps ended and that the share was becoming a potential buy.

Conversely, if the price were plotting above the upper band, the share is overbought. In that case, the trader would watch for a crossover of price below the upper band as a signal that it was time to consider selling.

The percentage variation of the envelope lines from the average can be changed. Instead of 10% as shown, variation could be, say, 20%.

In that case, more price data would be contained between the envelope's limits. Were a 20% variation employed, crossovers by price above the upper band or below the lower band would identify extremes of overbought or oversold respectively.

These signals could be used to anticipate major price trend changes likely to follow.

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