‘Keltner Channels’ is an indicator that measures market volatility. The original Keltner Channels were described by trader Chester Keltner in a book from 1960. However, the indicator has since been modernized, so today it closely resembles the Bollinger Bands© indicator, which is more well-known.
Keltner Channels consist of three lines: a middle, upper, and lower line, which often encapsulate the price chart. The middle line is just an exponential moving average, indicating whether the price is trading above or below the average for the period. The two outer lines represent the volatility of the security by using the so-called Average True Range, also known as ATR. To understand ATR, we refer to this article.
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It is precisely in the use of ATR that Keltner Channels differ from Bollinger Bands, as Bollinger instead uses the standard deviation to define the bands. The deviation indicates the difference between a stock’s closing price and the stock’s average price over a period.
For both Bollinger Bands and Keltner Channels, however, it is the case that the bands narrow when there is low volatility in the stock, whereas the bands widen apart if there is high volatility in the market.
As a trader, you can use Keltner Channels to assess the trend of a stock. If the price breaks above the upper band, you can expect that there is a strong uptrend in progress. Conversely, if the price breaks below the lower band, you can expect that there is a strong downtrend in progress.
If the market is not trending, you can expect the price to move within the upper and lower bands.
Strategy Using Keltner Channels
The Keltner Channels strategy is one of the indicators that we at Nordic Traders use ourselves to get an indication of where the market may be heading. However, this will always be in conjunction with other elements, such as the price development the day before, and the price development in the very short term.
An example of how one can trade using this is described below. Keltner Channels work well for finding an entry in a trending market, and that’s how we use it ourselves. You can use Bollinger Bands in the same way. Both indicators provide a very good framework for the interval in which the price normally will be. If the price exceeds either the upper or lower line of a Keltner Channel, it can often be seen as a sign that one can later expect the price to move even more in this direction. However, as mentioned, this should be combined with other factors to become an actual trading strategy.
We have used the following strategy to trade the german DAX index on a five-minute chart.
First and foremost, one must form an idea of where the market is generally heading. Even though we normally take our trades in the DAX index on a five-minute chart, we first look at the slightly longer trends on a one-hour chart and a daily chart and plot the most important support and resistance points. Before the market opens in the morning at 9 a.m., we also perform an analysis of what has happened after the market closed at 5:30 p.m. the day before, and what has happened in the Asian market. This can be checked here: Yahoo Finance Asia.
If the Asian market is either very negative or very positive, it can increase the likelihood that the European markets will continue in this direction. However, one must be aware that even in strong trends there are movements in the opposite direction, and it is not at all unusual for the DAX index to start by correcting 30-50 points upwards (or more), even if it is in the middle of a downtrend.
We also determine yesterday’s price range in the period between 9 a.m. and 5:30 p.m. to analyze how positive or negative the market is. The clearest scenario occurs when there is an ‘extreme gap’ upwards or downwards – that is, the market opens either higher or lower than it has been at any point the day before. See an example of this below.
In this screenshot, yesterday’s price range between 9 a.m. and 5:30 p.m. is marked with two black lines, and the black arrow indicates where the market opens the next day at 9 a.m. This price is lower than it has been at any point the day before, and thus there is an increased likelihood that the market is negative and will continue to go down during the day. This is called an ‘extreme gap’ downwards.
The reason why this is not always as easy to trade as it may seem is that it can be difficult to predict exactly when the market will move further down. Quite often there will be a correction of a certain size upwards, for example, up to the bottom of yesterday’s price range, before the market continues down.
When you have made some overall considerations about where the market is heading, you can zoom in and use Keltner Channels for further confirmation. Below is an example of how the market behaved on July 5th after an extreme gap downwards had occurred. Here we are zoomed in on a 5-minute chart and shortly after the market opens at 9 a.m., the price drops below the bottom of the Keltner Channel, which we can see as another confirmation that the market will continue downwards. Here it is important not to be too eager, as you typically find yourself in a situation where you might be at an extreme point when the channel is pierced. So we wait for the price to pull back up towards the middle band of the channel, which is an exponential moving average, and when the price is around there and subsequently shows signs of moving downwards and forms a red bar, then we have the opportunity to go short.
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If the price soars upwards and forms one green bar after another, then you do not go short. You wait for the hypothesis that the market will continue downwards to be confirmed. As you can see on such a day, there can be quite a few signals where the price first pierces the channel, then pulls back towards the moving average, stops, and moves further down. It’s not always that you see so many good signals in a single day as in the example below. Usually, the first two or three signals in the same direction are the most valid. After that, you may well risk that there is no more fuel in the trend.
This strategy works as an effective tool when entering a market with a clear trend and can thus be described as a kind of trend-following strategy. If you are in a period where the market moves more sideways on the daily chart and possibly lies in a narrow price range, then it will not work as well. You should also refrain from trading it on days when major news comes out later in the day, for example, when Jerome Powell, the director of the American central bank, speaks later in the day or evening. On these days, there is a tendency for the market not to move much, and therefore you cannot consider it a valid signal that the Keltner Channel is pierced.
In this example, we have used standard settings for Keltner Channels, which are an EMA period of 20, an ATR multiplier of 2, and an ATR period of 10.
You can use Keltner Channels with the trading platform Markets by clicking “Indicators” and then “Keltner Channels”.
