Use Price Envelopes for Trading Stocks

By Dr. Winton Felt

There are a couple of methods of creating trading envelopes around the price action of a stock (or any security) with which the trader should be acquainted.  It is well known that moving averages are used to smooth out the price activity of a stock and that the moving average also can act as support or resistance.  The longer the time-span used in computing a moving average, the more powerful that average will be in its ability to offer support or act as resistance.  Stock prices will fluctuate, with quotes appearing on either side of the mean.  The moving average is, in fact, the central tendency of all the quotes over a given period.  Prices fluctuate around a moving average in cyclical patterns of approximately similar proportion.  Since the moving average reflects the shape of the moving trend, then the extremities of prices on either side of the average will trace out a pattern that also resembles the moving average.. 

Therefore, copies of the moving average can be placed at equal distances on either side of the average, and they will serve as markers that define the approximate probable boundaries of the price action.  Of course there will be quotes outside those boundaries, but copies of the moving average can be placed at a distance from the central moving average that will envelope 50%, 60%, 90%, or any other portion of the stock's activity.  Where to place those lines will depend on what the trader wants to accomplish.  There are plenty of charting programs available that will enable the trader to plot the bands 5% (or any other percent) above and below the average.

There are too many different ways to create a price channel to mention them all here.  One more example would be to start by averaging the high, low, and close for each day and then plotting the moving average of that average (call this average "A").  Then you could compute the average daily range (high – low) over the same period (call this average "B").  Then add average "B" to average "A" to get the upper band.  Subtract average "B" from average "A" to get the lower band.  A charting program can plot the stock along with its price channel on a daily basis.

For example, if the trader wants a relatively high probability of capturing a gain, then he will place the duplicate of the moving average at a fairly small distance from the central moving average, and he will have to be satisfied with smaller gains and more frequent trading.  If he wants larger gains, he can place the duplicate moving averages further away from the mean.  The stock's prices will reach the upper band less often, but when it does reach it, the gain will be greater.  The further the bands are placed from the center, the more likely it is that the trader will ride out several declines before he can get a profit.  A greater distance also means that many smaller gains will be ignored until they simply melt away.

Another consideration here is risk.  If the upper band is placed at a relatively great distance above the mean, then it should not be relied on as the sole strategy for selling.  Our stockdisciplines.com traders always assume there may be an emergency.  Therefore, they always use a trailing stop loss or a sensitive selling strategy that will get them out before they incur significant loss.  Trading within an envelope as described above plays on small rises and small declines.  That means profits will be small and losses must b kept under strict control.