Trading With Toli: How to Use Moving Averages and Price Envelope Bands

Last week, we discovered how to identify trends and use trendlines to help us set up positions in those markets. This week, we’ll continue along the natural progression of trend indicators to use, with moving averages and price envelope bands. To understand these tools and their value in evaluating trending markets let’s visit our pal Jack Schwager and his trusty rules for defining trendlines and the price action channels created by price envelope bands:

1. Declines approaching an uptrend line and rallies approaching a downtrend line are often good opportunities to initiate positions in the direction of the major trend.
2. The penetration of an uptrend line (particularly on a closing basis) is a sell signal and the penetration of a downtrend line is a buy signal. Normally, a minimum percentage price move or a minimum number of closes beyond the trendline is required to confirm a penetration.
3. The lower end of a downtrend channel and the upper end of an uptrend channel represent potential profit-taking zones for short-term traders.

We’ve previously discussed at length the subjectivity and “importance” of trendlines and channels last week. What matters to us this week is understanding the concept of leveraging the general direction and areas price travels on a chart. 

Through Schwager’s general guidelines, we begin to picture moving averages as approximations of trendlines and price channels as approximations of price envelope bands, such as Bollinger bands. Let’s dissect how both of these indicators are created and used to spot buying and selling opportunities.

Moving Averages

“A moving average provides a very simple means of smoothing out a price series and making any trend more discernible.” 

For example, a 20-day moving average will take the average close of the past 20 days, ending with the current day. The set numbers being averaged are continuous, moving through time (as you can see with the line).

A simple way to use moving averages effectively is:

1. Identify if it is rising or falling. It will rise if today’s close is higher than the average of the previous days and vice versa.
2. Once a trend is determined, pick a minimum number of ticks reversing a moving average you would like to use for buy/sell signals (eg: 10 ticks)

From looking at the chart, one can see the first buy signal and the following sell signals end up not being profitable but the third signal ends riding the whole way up. 

As you can see, moving averages are great at expressing the general trend of a market by smoothing out the noise price fluctuations make. However, this functions at the cost of lagging behind immediate and sudden moves. Therefore, solely using a moving average or one indicator is NOT ENOUGH to fulfill a trade.

In range-bound markets, moving averages do little but bring confusion. Price will simply whipsaw back and forth between the MA given its nature. Using the same logic of 10 ticks every reversal of the MA, with the chart below this time will prove itself catastrophic.

Price Envelope Bands

Price envelope bands are derived from moving averages. Moving averages are most commonly used to spot trends. Price envelope bands can help do the same as well as demonstrate support and resistance areas. 

PE bands take a moving average and add a given percentage to the moving average’s price level for the PE’s upper boundary and subtract the equivalent percentage for the lower boundary. The given percentage should create an envelope encompassing most of the price activity.

Practically speaking, if price hugs either boundary, it can point to indicating overbought or oversold levels according to Schwager. In my humble opinion, they are good for pinpointing more precise entries in smaller time frames and for taking profit. But, in the end they produce more of the same problems as moving averages.

Signals with bands would generally be buying in oversold levels and selling in overbought levels. However as we’ll come to hear from John Bollinger himself, price tagging a boundary is not inherently a buy or sell signal.

There are several different ways to compute bands. Bollinger Bands, for example, add and subtract a standard deviation to the actual price instead of a given percentage. Because of this difference, Bollinger Bands help distinguish range-bound and trending markets with the contraction and expansion of their width with volatility. 

Bollinger bands are extremely popular amongst technical analysts and traders. John has laid out 22 essential rules to using his tool properly.

I agree with Bollinger’s contention that one should use different types of indicators to form a complete trading thesis. Pairing a momentum indicator such as Bands should complement other types of indicators such as volume indicators instead of another momentum indicator. Only by doing so can a trader find relevant confluence.