Envelope Channel

What Is an Envelope Channel?

Envelope channel refers to upper and lower bands around price bars, generated by a moving average and a pre-determined distance above and below the moving average. The distance can be calculated through a percentage variable higher and lower than the moving average (i.e., 2%, 5%, or 10%,), or the number of standard deviations (i.e., 1, 2, 3, similar to Bollinger Bands).

Unlike traditional price channels, standard deviation-based envelope channels change over time in response to a security’s volatility by widening or narrowing the bands.

Understanding Envelope Channels

Envelope channels can be created using a variety of techniques, so long as they work together to form upper and lower bands that surround the security’s price.

For example, a trader may use a 20-day simple moving average and 5% distance to generate an envelope channel for a given security. Other examples might include Bollinger Bands or Keltner Channels, which are volatility-based envelopes created using exponential moving averages.

Many traders react to a sell signal when the price reaches the upper band and a buy signal when the price reaches the lower band of an envelope channel. Often times, traders need to experiment with different moving average and distance settings to find what works for a given security or market. They should also watch for breakouts and breakdowns from envelope channels in more extreme circumstances because those signals may generate greater reliability and profitability.

Other technical indicators or chart patterns can be helpful in confirming reversals, lowering the frequency of false buying or selling signals.

Envelope Channel Example

Charting services define and calculate the envelope channel in different ways. For example, Worden's TC2000 envelope channel utilizes a moving average and percentage distance above and below the moving average.

The indicator is set to a 20-day simple moving average and 6% distance in this Apple example, drawing upper and lower bands that contain the vast majority of price movement between October 2017 and August 2018.

Image by Sabrina Jiang © Investopedia 2021

A rally surges outside the top band in November 2017, setting off a sell signal that precedes a minor decline, followed by a three-month trading range. A decline into February cuts through the bottom band for a week, triggering whipsaw losses if dip buyers enter too early. The bounce into March reverses at the top band but the stock posts a slightly higher high before turning sharply lower mid-month.

April and May buying signals yield healthy profits while the rally into Memorial Day stalls outside the top band, generating a prolonged consolidation pattern. Finally, the August surge to a new high issues another false sell signal, telling traders to reexamine indicator settings.