Percentage envelopes enhance the usefulness of a single moving average. These envelopes help determine when the market has gotten overextended in either direction by showing when the prices have strayed too far from their moving average line. To accomplish their task, the envelopes are placed at fixed percentages above and below the average. In example, shorter term traders, like those in swing trades, most often use 3% envelopes around a 21-day moving average. So when our trader sees the prices reach one of the envelopes (3% from the average), he knows the short term trend is overextended. For longer term trades, like those who may be trading options, some possible combinations are 5% around a 10-week average or a 10% around a 40-week average.

The rough graph below shows what the trader would see using 3% envelopes around a 21-day moving average. Note the areas where the price bars extend outside the upper and lower envelopes. This is where the graph suggests an overextended market.

Andy Swan is co-founder and head trader for DaytradeTeam.com.  To get all of Andy's day trading, swing trading, and options trading alerts in real time, subscribe to a one-week, all-inclusive trial membership to DaytradeTeam by clicking here.