Envelopes refer to moving average bands and channels, which consist of a middle and two outer bands. Envelope theory states that prices are most likely to remain within the boundaries of the envelope. When prices go outside the envelope this can indicate an overbought/oversold situation.
An envelope is generally two moving averages, one adjusted to be above price, the other adjusted to be below. Typically, an envelope defines the limits of a security’s normal trading range. In use, traders tend to trade reversals using the bands – e.g. if price penetrates the upper band they go short, if it penetrates the lower band they go long. The definition of the band depends to a large extent on volatility, which is why Bollinger bands are so useful – they self-modify as volatility expands and contracts. Envelopes can employ simple moving averages, exponential moving averages, or other more complicated averaging strategies. Day traders make extensive use of envelopes, and in fact you could argue that the SureFireThing Camarilla Equation uses ‘reversion to mean’ theory to generate a number of pseudo-envelopes which sit around a nominal center point providing incredibly useful day trading signals (although they also provide breakout points, not just reversals). They tend to work best on liquid stocks, as they track the market’s expectations, and the more liquid a security, the closer it approaches ideal behaviour..