A Story About Simplicity and Moving Average Envelopes

23 Feb 2022

ZB1!

First, a short story. I like simple stuff. Maybe it's just me (I don't think so) but the more complex my process becomes, the worse the trading results. In 1987, four years into my career, I used a combination of Wyckoff and Elliott to make a series of very profitable bond market calls for my institutional clients. I spent my days and nights obsessed with counts, counter counts, alternate counts, Wyckoff sequences, oscillator nuances…. In other words, all the shiny complex things were in play. Needless to say, I came out of the experience a legend…. in my own mind. In retrospect, I had loads of confidence but very limited real knowledge or experience. It's counter intuitive, but the success of 1987 was detrimental to my growth as a trader/analyst.

After the great results/luck during the tumult of 1987, 1988 proved difficult. My Elliott count became muddied, I often misread the Wyckoff price volume relationships and while not disastrous, my results turned quite ordinary. As the results worsened I responded by adding ever more complexity to what was an already complex routine. To make a long story short, as complexity increased, results worsened. To suggest that I became frustrated would be an extreme understatement. I questioned my future as a technician/trader.

I remember walking into my office one morning after a particularly bad week and deciding that things had to change. I decided to immediately begin simplifying my process. I retreated to basics. Happily for me, as I eliminated complexity I found better results. Over the next few years I continued to simplify and to refine my risk management approach. By simplifying and becoming less risk tolerant I became an effective trader/analyst. Simplicity is robust, it is typically fractal, and reduces difficult decisions to ordinary. Simplicity is also a process. Most only arrive there after a long journey.

Moving average envelopes certainly fall into this "simple is simply better" approach.

• Construction is simple and intuitive.
• Construction is easily adapted for any market or time frame.
○ This is important because every market has a specific character. Some trend for long periods while others chop and mean revert with regularity.
○ Importantly, character changes over time. It had been four years since I last updated my bond moving averages, the changes were significant.
○ Part of this probably has to do with the level of Fed involvement. I don't think I had significantly updated my bond envelopes for nearly thirty years prior to this adjustment.
○ Part of this has to do with the level of interest rates. At lower levels of rates, prices are generally more volatile as durations (a measure of rate sensitivity) become longer.
○ Because the envelope construction is revisited periodically it remains current to changes in market state and condition.
○ Don't assume that envelope settings that work on 30 year futures will work on 10s or 5s. Differences in duration create large differences in volatility
○ Also, the settings that work well on futures won't translate to yields. Using percent change (envelope tops and bottoms are placed at percentages of the moving averages) on a percentage is just wrong. I see supposedly financially literate people do this all the time… what the hell?
Building the Envelopes:
• The average and the width of the band is an eyeball approximation. Nothing fancy.
• Choose one of the available moving average envelope studies available. I used one created by H-potter.
• Set average 1 up so that the upper and lower bands follow the price action closely.
• Set average 2 up so that the upper and lower bands generally tag the next higher perspective swing points.
• Set the third average up so that the upper and lower bands tag the highs and lows of the next more volatile set of swings.
• I often add a fourth set of bands that tag the next higher perspective highs and lows.
• Don't get carried away. Keep it simple and intuitive.
• I am intentionally not providing my settings. I don't think they are important but I think its important for you to go through the process for the particular market and time frame you are working in.
How I use the Envelopes:
• Convergence of the upper or lower bands suggest that the market has become overbought or oversold.
• Odds of correction, even if laterally, expand significantly when the band extremes converge.
• You would never buy or sell based upon the convergence. But you might reduce a long/short position or begin monitoring for reversal behaviors as the bands come together.
• I generally use the warning of an extended trend given by the bands to begin closely monitoring price action, searching for tradable setups with good risk reward characteristics.

Conclusion: Simplicity can provide a real edge while complexity often becomes a headwind to success. This simple moving average envelope system can be modified for nearly any market or time frame and is adaptive over time.


Good Trading:
Stewart Taylor, CMT
Chartered Market Technician

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