Envelopes Indicator now available for all stock indices

About the Envelopes indicator and how we implemented it

The Envelopes indicator is a very simple, but powerful way to determine if an index is overheated or oversold (if someone knows the correct opposite of the word "overheated" please let me know..).

Basically, the Envelopes are shifted copies of an SMA. On https://www.advance-decline.net we use the SMA20, which is a fast and short-term simple moving average, and then add or subtract a few percentage points (our formula is a bit more complex, but you get the point). This provides two lines - the lower and the upper Envelope line, with each of them having a fixed distance to the middle, the SMA20.

From our experience we know that the price tends to oscillate between the upper and the lower Envelope lines. Those lines act as a first line of support or resistance, maybe let's call them "soft resistance and support". Usually, the price will bounce at this line, moving again in the opposite direction for at least one time period.

Sometimes the price will cross those "soft" Envelope lines. Thereis then an additional chance that the price will bounce at envenlope_line plus/minus 1%. This is why we decided to use upper and lower Envelope bands for our version of the Envelopes indicator.

By the way: It is the same with some SMAs, e.g. the SMA 200. Sometimes you can observe that the price will not bounce at the SMA 200 directly, but at SMA 200 minus one percent. This principle is simply being applied to the Envelopes indicator.

An example for applying our Envelopes indicator to a stock index

Below is a screenshot of our Envelopes indicator for the German tech index TECDAX:

 

The TECDAX has been very strong for some weeks now, knowing only one direction: Upwards.

The Envelopes need at least 20 time periods until they can start, which is why those bands start in the middle of the chart.

The example above is actually untypical because the TECDAX is so strong at the moment. Instead of staying within the Envelope bands most of the time, the TECDAX moves forward within the upper band or even above. This helps you to determine the current strength of the trend. The (bullish) trend is very strong if the price moves within the upper band or above for a longer time, which is what we're seeing here. 

This example also shows the danger of only relying on this indicator: Like every other indicator, it can give false signals if you want to sell every time the price touches the upper bands. Instead, it can also happen that the price will stay within or above the upper band for some periods, then come back to the area between the bands, only to touch the upper band afterwards again.

It will be hard to apply a strategy which is only based on touching or crossing the Envelope bands. But the reason why we introduced this indicator, although we know about its weaknesses, is the fact that Envelopes help to see the bigger picture. This is a bit similar to market breadth data which also helps you to see more.

With the Envelopes, you can clearly determine if an index is overheated or not and how likely it is that the price will go up or down. 

Combined with market breadth indicators, the Envelopes will help you to determine the current state of an index. 

Of course the Envelopes can be also applied to any other security, such as a stock or a crypto currency. Please note that Envelopes become a bit useless when the security is very volatile. In our cases, when being applied to indices, the Envelopes will be very useful because indices tend to be less volatile than individual securities. 

What about other "classic" indicators?

Actually we have already prepared other indicators: The RSI (the version from TradingView which gives the same values) and the RSI cyclic smoothed v2. The latter is a modified version of the RSI (published on TradingView) which takes also cycles into consideration.

We still don't know if we should add those or other indicators to the website since they are not market breadth indicators. In addition, one could ask why we picked those specific indicators and not others, such as the Bollinger Bands or the MACD.

The truth is that the people behind this blog and website all have their own system for trading and investing. Some of us rely on those indicators because of their personal preferences, but there is no good fact-based explanation why e.g. the RSI should be used together with market breadth indicators and not the MACD (this is just an example).

Summary

The main message of this blog post should be that one class of indicators usually should not be used alone to make a decision. Instead, multiple ways of looking at an index should be taken into consideration. We just think that market breadth data should be one of the things you should look at, and everyone can decide for themselves what other aspects play an important role.

For now, we've decided to add the Envelopes since it plays along very well with the McClellan indicators. It is a personal decision and you might not agree with us - that's ok and we respect that.