A moving average envelope, coupled with RSI, offers a powerful trading strategy for a breakout market.

A moving average is one of the most commonly employed technical indicators. It averages the price of a currency pair over a given period of time, with the calculated average “moving” as the earlier prices fall out of the dataset and are replaced by newer ones.

The dataset used to calculate moving averages can be based upon any price: highs, lows, opens, closes. Greater weight can be given to recent prices, as in exponential and weighted moving averages; or to the prices in the centre of the dataset, as in triangular moving averages; or the weight assigned to various prices can alter depending upon price volatility, as in variable moving averages.

A moving average is by definition a lagging indicator, because it shows where the price has been. However, it can also be used to illustrate the buying or selling pressure on a currency pair as a leading indicator, showing where the price is going.

When calculating moving averages, changing the number of time periods used in the calculations changes the sensitivity of the indicator: averaging over a greater period of time smoothes out the fluctuations (microtrends) in the price action, whereas averaging over a smaller time period allows for greater sensitivity but can lead to false signals in a volatile market.

Each trader develops his or her own favorite number of time periods for calculating moving averages. This trading technique is based upon two five-period simple moving averages, one calculated from the preceding highs and the other from the lows, both lines plotted atop the currency pair’s chart.

The lines form an envelope similar to Bollinger bands, with prices in a rangebound market fluctuating between the lines. However, strong buying or selling pressure, such as generated by a breakout from the range, moves the price beyond the envelope and signals the breakout. The trading signal is generated when the second candlestick or heiken ashi closes outside the envelope.

Trade confirmation comes from the RSI, not when it first crosses the overbought or oversold lines, but when it crosses back above the 30 level or below the 70.

Closing the trade is determined either manually, by noting when the heiken ashi become smaller and retreat back inside the envelope, or with a trailing stop to lock in profits when the market turns against the trade.

Note that on the one-hour AUD/USD chart below, the yellow moving average lines give a framework by which to judge the price action. When the buying or selling pressure is very high, the heiken ashi open and close outside of the envelope, and appear to ride the wave of the moving average both going up and going down.

Note also the RSI below as it confirms the buy or sell signal, marked with a red circle for clarity.

This strategy doesn’t call the tops or bottoms of price fluctuations, but consistently and reliably indicates profitable trades.