Drawbacks of Envelopes
The problem with relying on moving averages to define trading signals is easy to spot in Figure 1. While the winning trade shown in that chart was very large, there were five trades that led to small gains or losses over a five-year period. It is doubtful that many traders would have the discipline to stick with the system to enjoy the big winners.
To limit the number of whipsaw trades, some technicians proposed adding a filter to the moving average. They added lines that were a certain amount above and below the moving average to form envelopes. Trades would only be taken when prices moved through these filter lines, which were called envelopes because they enveloped the original moving average line. The strategy of placing the lines 5% above and below the moving average to form an envelope is illustrated in Figure 2.