By Anthony Trongone Ph.D., CFP, CTA*
Posted: Feb 6, 2009

In this current, free-falling market, trending indicators are still sending accurate signals. These continuation patterns perform best in a stormy market because they encourage trading at the onset of a downward trending market by placing lines above as well as below the existing price of an instrument. These boundaries signal a trading opportunity.

Many market participants use these boundaries as a reversal strategy — that is, when they approach these lines, they see it as an opportunity to take an opposite trading position; however, if you were trading the cues (ticker: QQQQ), which fell from $48.30 on August 18 to $25.56 on November 20, 2008, this would not have been a profitable strategy.

Another popular tactic is to use these boundaries as a breakaway strategy. This breakaway approach is simple to implement: If the price of an instrument rises above the upper boundary, it is seen as a buying opportunity; conversely, if it falls below the lower boundary, it becomes a selling opportunity.

Although there are numerous ways to anchor these lines, many intraday traders fall prey to the same common weakness when applying these indicators: They do not draw these lines from market volatility within the same intraday period but calculate its moving average from earlier intraday periods. Before I explain this, let’s look at one such indicator within the Basic Study pull-down menu of eSignal:

In the help menu, the following description applies to envelopes:

An envelope is composed of two moving averages. One moving average is shifted upward, and the second moving average is shifted downward.

Envelopes define the upper and lower boundaries of a security’s normal trading range. A sell signal is generated when the security reaches the upper band, whereas a buy signal is generated at the lower band. The optimum percentage shift depends on the volatility of the security — the more volatile, the larger the percentage.

The logic behind the envelopes is that overzealous buyers and sellers push the price to the extremes (the upper and lower bands), at which point, the prices often stabilize by moving to more realistic levels. This logic is similar to the interpretation of Bollinger Bands.

eSignal allows you to select your own individual settings:

In this study, we are using a 60-minute time frame, going back eight (60-minute) periods to draw a 2% boundary above, as well as below the closing price.

Because we are confining our trading to the 9:00 – 10:00 a.m. hour, we are including premarket activity to draw our boundaries for this hour of trading. Using premarket activity produces a narrow boundary because price swings in the premarket session generate less volatility. Therefore, when you begin trading at 9:00 a.m., you are confronting tighter bands but will experience wider price swings — this combination artificially produces more trading activity.

The line chart shown below has an envelope using an 8-day moving average with a setting of 2% in either direction of the closing price (black line). The fact that it contains a dynamic time frame consisting of 8 consecutive 60-minute periods restricts our trading opportunities.

The envelope keeps the trading signal from breaking away from the blue lines. The signal is the black line residing in the middle of the two outside blue bands. Despite a strong downward trending market, the signal does not give us many trading opportunities. Although you can tighten the bands more by selecting a smaller percentage range, this approach is likely to produce too many unprofitable trades.

Fortunately, eSignal allows us the flexibility to specify the time frame. In the bar chart shown below, the envelopes are drawn by restricting the analysis to the 9:00 – 10:00 a.m. time period.

This offers us the opportunity to clearly visualize hourly price swings, as well as trading volume. In 120 trading days (June 4 to November 19, 2008), the 9:00 – 10:00 a.m. period averages 25 million shares with a daily price range (highest – lowest price) at 54 cents.

In the earlier hour, the cues saw 3 million shares trade, but the hourly price range fell to 33 cents. The 7:00 – 8:00 a.m. trading range had less activity, 535,000 shares with an average range of 25 cents.

The bar chart shows trading during the 9:00 – 10:00 a.m. hour; the blue lines indicate a 2 percent envelope band with an 8-day moving average.

The chart clearly displays the activity between 9:00 and 10:00 a.m. The length of the bar indicates volatility. Price swings become more apparent as the cues fall below $36. Unlike the earlier chart, with free-falling prices, it clearly shows the hourly price outside its 2 percent lower boundary. Therefore, it has two advantages: It provides a better perspective on downward momentum, and it makes it easier to compare differences in trading volume within this hourly time frame.

This method does offer you a better understanding of recent price swings within your trading zone; however, it totally disregards the other hourly trading periods. I suggest taking a more inclusive approach. When formulating your 9:00 – 10:00 a.m. trading decisions, use the earlier price swings but give them less emphasis. Most of your focus should be on recent pricing volatility during the hour under investigation.

Below, you will find the results of the Tool + Data Export feature in eSignal using envelopes with settings of (8,2,C). On the far side of the table are my calculations: 8-day simple moving average, upper envelope = (8-day SMA * 1.02), and lower envelope = (8-day SMA * .98).

*Reprinted (and modified) with permission from Anthony Trongone Ph.D., CFP, CTA, the Director of Executive MBA Programs in China for Centenary College. He is one of the trading educators featured on eSignalLearning.com. You can write him at: trongonea@gmail.com.