Channels are handy for highlighting price reversals, but you can also use them to work out the direction of a market trend.
- Calculation for the Keltner Channels
- Using Keltner Channels
- Examples with the Keltner Channels
Keltner channels act as a price reversal indicator. The indicator measures how volatile the market is by focusing on price moves in bands formed by high and low moving averages, in a way that resembles the action of the envelope channel. The overall trend of the market is signaled by the direction of the Keltner channels.
When a price trends above the high band, it’s a sign of overbuying, and when it dips under the lower band it points to overselling.
When a trader sees the price head over the high band, they may take it as a signal to sell short, and a dip under the low band as a signal to buy long.
Calculation for the Keltner Channels
The calculation for Keltner channels relies on the average true range, which means whichever value produced by these alternatives comes out highest:
- The present period’s high, minus its low
- The difference between the prior period’s close and its high
- The difference between the current period’s close and its low
This differs from other tools like Bollinger bands which use standard deviation to work out the limits of the high and low boundaries. The envelope channel features two bands whose distance from an n-period moving average of the price is calculated as a fixed percentage.
The Keltner channels are calculated as a function of a moving average of the “typical price” and a multiple of the average true range. The usual price comes from adding the high, low, and close amounts together and dividing the result by three.
Since the Keltner channels utilize average true range, the bands don’t react so quickly to price comparison in the same way as something like Bollinger bands. This generally means more overbuying and overselling signals will be produced but this will vary according to the chosen settings (you might adjust the moving average of the typical price and average true range, for instance).
Bollinger bands are still used more than Keltner channels, relying on standard deviation, which is thought to be more useful from a statistical point of view than the average true range.
For instance, when price moves beyond Bollinger bands with a standard deviation of three, traders will know that it should only occur 0.2% of the time, but if it moves beyond some multiple of the average true range and becomes less certain outside of some multiple of the average true range then the statistical meaning of that becomes less clear.
Using Keltner Channels
The higher you set the moving average of the typical price and average true range, the wider the bands will be. Set the moving average of the typical price and average true range lower and the width of the bands decreases. Wider bands deliver more conventional signals but not so many of them, while bands that are closer together will create a higher number of lower quality signals.
Your results will depend on how much you rely on the Keltner channels to create trade signals. If you are heavily dependent, then it makes more sense to use wider bands so you don’t get swamped with duff signals. Either way, it’s best to use Keltner Channels in conjunction with other tools and forms of analysis to better inform your trading decisions.
Examples with the Keltner Channels
As we said, you can set the Keltner channels however you like so they fit the needs of the market you’re trading in, the time period, and the signal quality that you’re after.
I our example, it’s set to a 20-period simple moving average of the usual price and a 4x multiple on the average true range. This is a somewhat severe setting which cannot calculate the chances of a price falling beyond this range. It will vary according to the asset, charting timeframe, and volatility of the market, and maybe some other factors too, but it’s going to be below half a percent in this case.
The market only broke out of the channel once between April and October 2016, at the point when the UK voted to leave the EU.
Keltner channels created a signal due to the dip under the lower band, and a concurrent touch of a psychological support level of 2,000 in this market.
You can see two or three other signals if you look further out in this market (according to whether you add to positions on any touch occurring later on a different candle). All are short opportunities triggered by a touch and breach of the top band.
Trend followers may not have taken advantage of these opportunities, and that’s all right because that means they were sticking to their own approaches in a disciplined fashion, which is very important for any trader. The success of these trades depends on the point where they were exited. They could have been winners, but they could also have turned into losers if they were held onto for too long.
You can use a different technical indicator such as MACD, Relative Strength Index, or another one to determine your point of exit. You can use candlestick patterns or areas of support and resistance on shorter timeframes and you might even rely on market opinions derived from fundamental analysis.
Additionally, for instance, you can plot a center line in the Keltner channel and use this as the point where you take profit. This is the moving average of the usual price over the period of concern (20 periods in this instance). Doing it this way gives some small wins.
Although trend followers may choose to pass on these opportunities, short positions can be used to hedge net-long exposure to stocks in any other trades that they may have open elsewhere.
Keltner channels are good at helping you to measure how volatile a market is, and are an effective indicator of price reversal. The strength of the resultant signals comes down to the settings that you use on the indicator. A price that leaves the wider bands is going to give you fewer signals but these will be more reliable ones. A price that shifts beyond the narrow bands will give you fewer signals but ones with greater reliability.
You can filter your signals even more by aligning the direction of trades with the trend. Use other indicators fundamental analysis to confirm your trades.