how envelopes work
traders can interpret envelopes in many different ways but most use them to define trading ranges when the price reaches the upper bound the security is considered overbought and a sell signal is generated conversely when the price reaches the lower bound the security is considered oversold and a buy signal is generated these strategies are based on mean reversion principles the upper and lower bounds are typically defined such that the price tends to stay within the upper and lower thresholds during normal conditions for a volatile security traders may use higher percentages when creating the envelope to avoid whipsaw trading signals meanwhile less volatile securities may necessitate lower percentages to create a sufficient number of trading signals envelopes are commonly used in conjunction with other forms of technical analysis to enhance the odds of success for example traders may identify potential opportunities when the price moves outside of the envelope and then look at chart patterns or volume metrics to identify when a tipping point is about to occur after all securities can trade at overbought or oversold conditions for a prolonged period of time example of an envelopemoving average envelopes are the most common type of envelope indicator using either a simple or exponential moving average an envelope is created by defining a fixed percentage to create upper and lower bounds let s take a look at a five percent simple moving average envelope for the s p 500 spdr spy image by sabrina jiang investopedia 2021the calculations for this envelope are upper bound sma 50 sma 50 0 05 lower bound sma 50 sma 50 0 05 midpoint sma 50 where sma 50 50 day simple moving average begin aligned text upper bound text sma 50 text sma 50 0 05 text lower bound text sma 50 text sma 50 0 05 text midpoint text sma 50 textbf where text sma 50 text 50 day simple moving average end aligned where upper bound sma50 sma50 0 05lower bound sma50 sma50 0 05midpoint sma50 sma50 50 day simple moving average traders may have taken a short position in the exchange traded fund when the price moved beyond the upper range and a long position when the price moved below the lower range in these cases the trader would have benefited from the reversion to the mean over the following periods traders may set stop loss points at a fixed percentage beyond the upper and lower bounds while take profit points are often set at the midpoint line 