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Envelope Indicator: Best Settings – Guide -Trading Examples

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Hello and welcome. I am J.J Edwards, and in this article, I will share my personal experience with the Envelope indicator. I will answer the most common questions and provide real-trading samples by delving into the deep details of the indicator. The goal is to learn all aspects of this technical indicator. ‘How to read the envelope indicator’, ‘when and how to use the envelope indicator on the forex chart’, as well as the calculation and the best settings for the envelope indicator.

If you’ve been keeping up with my articles on forex technical analysis, my market approach should already be familiar to you. A cornerstone of my technical analysis involves identifying overbought and oversold prices on the chart. By recognizing when the market is saturated due to buying or selling pressure, traders can anticipate market pullbacks. This classic strategy of mine aims to mitigate trading risks.

There exists a multitude of indicators designed to help traders identify saturated areas. Among these, the envelope indicator stands out as one notable example. This particular indicator bears similarities to the Bollinger band. If you’re not yet acquainted with the Bollinger band indicator, I recommend delving into this article. I’m confident it will enhance your understanding of overbought and oversold conditions in the market.

Historical Background of Envelope indicator

FxNews – The Envelope indicator is a key tool in technical analysis, built on the principle of moving averages. These moving averages have been employed to even out price information and spot trends. The Envelope indicator enhances this principle by incorporating two additional moving averages, set at a specific distance from the central line. This development probably came about as traders looked for methods to measure market volatility and conditions of being overbought or oversold.

What is Envelope Indicator?

The Envelopes indicator presents an additional trading strategy within a trend channel, either on a rollback or when the boundaries are breached. This tool, rooted in the concept of moving averages, constructs a dynamic range on the price chart. It’s within this range that the price is anticipated to oscillate for the majority of the market duration.

Let’s simplify the definition of the Envelope indicator. Refer to the chart provided below. This chart illustrates the EURUSD currency pair, specifically on a 4-hour timeframe from the fourth quarter of 2023.

What is Envelope Indicator? 

What is Envelope Indicator – EURUSD 4H Chart

While most traders primarily utilize the indicator for buy and sell signals, it’s important to note that the indicator offers additional functionality. Specifically, envelopes can serve as a trader’s assistant, providing valuable insights into whether the market is trending or ranging. This information is crucial, especially considering that ranging markets tend to bounce erratically. As a result, trading in range markets often carries a greater risk compared to trading in trending markets.

There are three primary types of markets, and the envelope indicator can assist us in identifying them.

  • Bullish Market: This refers to a market condition where the price of a trading asset is on an upward trend.
  • Bearish Market: Conversely, this is a market condition where the price of a trading asset is decreasing.
  • Range Market: This describes a market condition where the price of a trading asset fluctuates within a narrow price range.

The direction of the envelope indicator provides valuable insights. If it’s pointing upward, it signifies a bullish market, prompting traders to strategize their trades accordingly. If the indicator is trending downward, it suggests a bearish market. Lastly, if the channels of the indicator are moving sideways, it’s indicative of a ranging market. This information is crucial for traders to adapt their strategies to the current market conditions.

The following image provides a sample of a ranging market.

What is Envelope Indicator

What is Envelope Indicator – LTCUSD 4H Chart

How to Use the Envelopes Indicator in Forex?

Looking at the EUR/USD 4-hour chart, you’ll notice that the market fluctuates within the ‘envelope’ line. This channel serves as an indicator of the potential price direction. In this case, the channel is trending downwards, suggesting a bearish market. In such a market, my personal strategy would be to seek selling opportunities.

At the heart of the moving average, there’s a third line. This line signifies the average price over the 4-hour period, given that our chart is set to the 4-hour timeframe. If the chart were set to a 1-hour timeframe or any other timeframe, then the indicator would display the average price for that specific period.

The upper and lower bands act as buffer zones surrounding the middle one. All three lines are moving averages, forming a range within which the price might oscillate. Consequently, the ‘envelope’ indicator provides lagging data on potential bounce-off or rebound points in the market. You can visualize it as a ball bouncing between these two bands.

Please refer to the image below from the EUR/USD H4 chart. Take note of the areas where the market breached through.

How to read the envelope indicator

What is Envelope Indicator – EURUSD 4H Chart

Having observed the chart, I’ll now delve into explaining the rollback and boundary-breaking strategies associated with the ‘envelope’ indicator.

Envelope Rollback Trading Strategies

One of the most popular strategies among traders using the envelope indicator is the ‘envelope rollback’.

Envelope rollback: There are instances when the market bounces as the price hits the upper or lower line of the envelope indicator. In such cases, the market tends to retreat back into the tunnel, allowing the main trend to persist.

The image below serves as a prime example of the ‘envelope rollback’ signal.

Envelope rollback

Envelope rollback – US Oil 4H Chart

It’s noteworthy that the U.S Oil price bounced each time it made contact with either the upper or lower band. However, this image represents an ideal market condition where a trend is being followed. It’s important to remember that the market can display erratic behavior influenced by global economic conditions. Factors such as wars, changes in interest rates, or hawkish or dovish speeches from central banks can swiftly disrupt any technical analysis.

Envelope Breaking Boundaries Trading Strategy

Breaking Boundaries: If the price of a trading asset breaches the top or bottom line and sustains there, it could indicate a substantial shift in price direction. Traders often use this as a hint to modify their trading strategies.

The chart below shows the AUD/USD currency pair on a 4-hour chart. A strong bullish bias pushed the AUD/USD price beyond the envelope lines. The price remained outside the upper band for over 40 trading hours, suggesting that the market was saturated for a prolonged period. Interestingly, the more significant the overbought condition, the greater the potential market pullback. Think of it as a spring coil; the harder you compress it, the higher it jumps up.

Breaking Boundaries

Breaking Boundaries – AUDUSD 4H Chart

That’s precisely how the AUD/USD price responded to the extreme bullish pressure. As a result, the pullback went beyond where the bullish wave had started.

Best Settings for the Envelope Indicator

The envelope indicator is composed of three moving averages. Interestingly, the flexibility of the indicator’s settings allows us to modify the types of these moving averages.

There are four types of moving averages in the indicator’s settings:

  1. Simple
  2. Exponential
  3. Smoothed
  4. Linear Weighted

In addition to the moving averages, there are three parameters that can be adjusted within the indicator’s settings:

  1. Period: This is the number of time periods used to calculate the moving average.
  2. Deviation or the percentage width: This is the percentage that determines the width of the envelope. It’s set at a fixed percentage above and below the moving average.
  3. Levels: This is for adding and customizing the horizontal line at specific values on the indicator’s chart.
Best Settings for the Envelope Forex Indicator

Best Settings for the Envelope Forex Indicator

The best setting for the envelope indicator highly depends on the market condition. The ideal way to find the best settings is to eyeball the upper and lower bands of the indicator. The bands of the envelope must be near the highs and the lows on the chart. We can tell if the indicator’s setting is wrong if the bands are too far from the highs or too close to the center.

Best Settings for the Envelope Forex Indicator

Wrong Settings for the Envelope Forex Indicator

The indicator settings on MetaTrader 5/4 are completely off the grid when you attach it to the chart, as shown in the image above.

The default settings of the envelope indicator are as follows:

  • Period: 14
  • Shift: 0
  • Deviation: 0.1

The setting’s deviation seems to be off, as evidenced by the bands sticking too close to the market’s center. For optimal results, the deviation should ideally range from 0.5 to 1

The envelope settings for the chart below are set as follows:

  • Period: 14
  • Shift: 0
  • Deviation: 0.8
Best Settings for the Envelope Forex Indicator

Best Settings for the Envelope Forex Indicator – EURUSD H4

The chart shows lines for highs, lows, and areas that are overbought or oversold. You don’t need to dig into the chart’s past to adjust the settings because the market changes all the time. The settings we talked about are just right for this indicator, based on the current market trend. Now that you understand the envelope indicator, keep practicing and tweaking the settings to find your perfect fit.

How to Add Envelopes to MetaTrader 5

In this article, we are using the MetaTrader 5 platform. To add the chart to your MT5 platform, follow the step-by-step guide below:

  • Open MetaTrader 5 by clicking on the icon from the desktop.
  • Log in to your trading account from the terminal’s menu: File > Login to Trade Account.
  • Attach a chart of your choice to the platform from the Market Watch window. The Market Watch window can be accessed by pressing Control + M together.
  • Open the ‘Navigator’ window. The ‘Navigator’ window can be accessed by pressing Control + N.
  • Double-click on the indicator or drag and drop it onto the chart.

If you have followed all the steps correctly, the chart should look like this. However, I have changed the colors based on my preference. You can also customize it by adjusting the settings.

Best Settings for the Envelope Forex Indicator

Wrong Settings for the Envelope Forex Indicator

Interpreting Envelopes Trading Signals

Overbought Signal: The Overbought Signal is triggered when the price reaches or surpasses the upper envelope line, suggesting that the currency pair might be overvalued. This could indicate that the price is inflated, and a downward correction or reversal might be imminent.

Oversold Signal: Conversely, the Oversold Signal is activated when the price reaches or falls below the lower envelope line, signaling a potential undervalued condition. This might imply that the price is deflated, and an upward correction could be expected.

In the AUD/USD chart below, the market bounced back from the overbought area. When the price breached the lower lines, it pulled back inside the channel. This sample chart demonstrates how to use the envelope indicator in forex trading.

Envelopes Trading Signals

Envelopes Trading Signals – AUDUSD H4

Combining the Envelope Indicator with Other Indicators

Envelopes are part of the trend and volatility indicators. They help measure how fast a security’s price changes. Their main job is to check if a security’s price fluctuation over time is strong or weak. RSI, moving averages, MACD, and stochastic are similar. So, using another momentum indicator with envelopes might give us duplicate chart data. That’s why in this guide, I’ll use Ichimoku Kinko Hyo. This trend-following indicator gives info on support, resistance, and trend direction. You can learn more about the Ichimoku Cloud in the linked article.

For the third indicator, I’ll use the Awesome Oscillator. It helps us spot the entry point with its bar color and divergence signals. Besides the envelopes, I’ve also added the RSI indicator. It’s a backup tool to confirm when conditions are overbought or oversold.

Envelope Indicator with Other Indicators

Envelope Indicator with Other Indicators – NZDUSD H4

Gold Analysis with the Envelopes Trading Strategy

After examining the gold chart on the 4-hour timeframe, the settings for the envelopes are as follows:

  • Period: 14
  • Shift: 0
  • Deviation: 1

By adjusting the deviation parameter to 1, both the upper and lower bands of the technical indicator align with the highs and lows of the gold price. With this setting, the overbought areas are now clearly visible on the chart.

Envelopes Trading Strategy

Envelopes Trading Strategy – XAUUSD H4

Buy Signal:

  • The price of the trading security must breach the lower line of the envelopes.
  • The RSI indicator must hover below the 30 level. This confirms the market is oversold.
  • The emergence of bullish candlestick patterns. This could be a hammer, an inverted hammer, Doji, or a bullish engulfing pattern.
  • The next candle after the emergence of the bullish candlestick pattern is the entry point.

Sell Signal:

  • The price of the trading security must breach the upper line of the envelopes.
  • The RSI indicator must hover above the 70 level. This confirms the market is overbought.
  • The emergence of bearish candlestick patterns. This could be an inverted hammer, Doji, bearish engulfing pattern, or a long wick candlestick.
  • The next candle after the emergence of the bearish candlestick pattern is the entry point.

Target Profit:

  • The first target profit should be the median line of the envelopes, and the second target profit should be the upper line if you are bullish or the lower line if you are bearish.

I hope you have enjoyed this article. If you have any questions about the trading strategy, please do not hesitate to contact me. I will be glad to address all of your questions.

  • 25 December 2023
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