The Keltner Channel is a volatility based trading indicator that uses two bands and the average true range to set the channel distance below and above an exponential moving average, generally 20 period EMA.
You use the Keltner Channel to determine when a market has stretched too far from the moving average – the average price of the market of N number of days. Using Keltner Channels as part of a trading strategy takes advantage of a volatility based trading indicator which allows us to trade markets that are showing good price movement.
Trading indicators are derivative of price meaning that the results that you see via a trading indicator will come via a calculation using the price you see on your chart. This is a long winded way of saying that all trading indicators, including the Keltner Channel, are going to lag actual price movement.
- Price first
- Indicator second
Channels can make a for a good trading strategy because they can not only show what “normal price movement” should be but also when a price event happens outside the normal behavior of price.
How Do Keltner Channels Work?
Keltner channels work by combining the average true range of an instrument and then plots the multiple of the ATR above and below the exponential moving average by using bands.
Keltner channel settings are based on several inputs that you can change depending on your charting platform:
- Moving average length (will determine lag time of channel)
- Average true range (ATR)
- Band multiplier (uses ATR reading)
- Moving average type (EMA, SMA)
- ATR type (EMA, SMA)
The Keltner Channel is calculated as follows:
- Middle Line: 20-day exponential moving average
- Upper Channel Line: 20-day EMA + (ATR X N multipler)
- Lower Channel Line: 20-day EMA – (ATR X N multipler)
The band multiplier is a very important number as it will determine how tight the outer and lower bands are to price.
As an example of band distance:
- .8 X ATR will have bands closer to price movement which can render the indicator useless as price will routinely breach the upper and lower bands
- 2.5 X ATR will have bands further from normal price movement and the channels will only have price breach upper or lower channel line when a significant price move happens
If the bands are tight, you may get a lot of excursions to the bands and beyond. This may be suitable for those scalping or day trading with the Keltner channel but not suitable for those looking for longer term plays in their instrument.
How To Trade With Keltner Channels
It is the buying and selling by humans (and computers although the trading programs are programmed by humans) that will move price. As humans, we are susceptible to emotions and beliefs and emotions are even more vulnerable when money is on the line.
Channel trading, and this includes Bollinger bands and moving average envelopes, are theoretically designed to surround the general price action of the charted instrument. You can use channels to determine when a market is oversold or overbought when you consider the price relationship to each side of the trading channel.
The key words are “general price action” because anything seen outside of the general movement of price can be considered an extreme movement.
One way to envision this general movement is consider that the price is travelling without an extreme bullish or bearish bias. While there may be an overall bias in one direction, there is nothing out of the ordinary with the movement of price.
There are times when a “that’s different” moment takes place and the price will make a move in one direction or the other. You will see price break either the upper or lower bands and that indicates that something has changed in the market.
This is the time when you want to be on alert for potential trading opportunities as it is clear that volatility has increased. You use the word potential because you don’t want to take a trade based on one indicator alone.
Keltner Bands & Moving Average Can Be Trade Locations
There are other things to consider but we can use the Keltner channel bands that surround price and the channels moving average as an alert for possible opportunity.
The bands do not act as a physical barrier to price just as moving averages do not magically support price.
They are a measure of volatility in the case of the bands and consensus when referring to moving averages. Both price volatility when price is showing strong movement and when price is in balance are places for potential trading opportunities.
The average true range calculation of the Keltner shows us when there is an expansion in the price range of price which indicates some type of stimulus is hitting the market to move price.
Keeping that truth in mind, you can see how important it is not to just “push the buttons” because the price has found itself in those locations.
Moving Average = Agreement of Price
The Keltner channel is plotted with two outer bands and through the middle is a 20 period exponential moving average (EMA).
Using the moving average, the middle line, as an area of general agreement in price, we can see when price moves away from it that one side is favored over the other. The further price moves away, the more we expect a snap back in the price.
The moving average can also act as the landing zone after the price makes the snap back and when I say zone, I mean we don’t expect price to land directly on the average. That is why we don’t simply execute trades when price is supporting or resisting in the area of a moving average.
Keltner Channel VS Bollinger Bands
The Bollinger band is calculated using a standard deviation while the Keltner uses ATR (average true range).
The Keltner Channel uses an EMA as opposed to the Bollinger Band which uses a SMA. There is a slight difference between an exponential moving average and simple moving average in terms of sensitivity as the EMA will react quicker to any major move in price.
You can visually see how Bollinger bands reacts differently with sudden price shocks.
That “balloon” effect happens because Bollinger Bands are based on the standard deviation. When price moves out of congestion range as this example shows, the bands stretch far from price. The Keltner Channel on the other hand is smoother which makes it easier to spot trends in the market.
The “balloon” effect of the Bollinger Band combined with the smoothness of the Keltner can give us another trading indicator.
Bollinger Band Squeeze
Some traders utilize the Bollinger bands and the Keltner channel together to show a Bollinger Band Squeeze. When the Bollinger is inside the Keltner, the squeeze is on. This indicates a trading range is occurring. As a trade setup, the movement of the bands outside of the channel is the trigger. This would indicate that the price is potentially about to go on a run as price breaks from the trading range.
Whether you are going to use the Keltner channel or Bollinger Bands for this trading system, is not the point. You can use either because it is the concept we are looking at.
Price Channel Trading Plan
The original Keltner used a 10 period for the moving average but it caused traders to be whipsawed around far too much. Over time, the popular setting became a 20 period EMA, a 20 period average true range and a 2.25 multiple. These settings were brought to use by Linda Bradford Raschke.
You can of course test various settings but in the end, we are simply looking for price engaging with either of sides of the channel.
How To Use Keltner Channels to Trade Pullbacks
Trading pullbacks is best done in a market that has exhibited a strong push in a direction in a trending market. This is based on swing analysis where you want to see conviction in a market swing that indicates another move in the same direction.
Using the Keltner channel, we can use price travelling outside the bands as an indication there was conviction in the swing.
If we are trading in an downtrend, you want to see price travel to the bottom channel and plot outside of the channel. Even a shadow plot is sufficient if you are a more aggressive trader.
An excursion outside of the channel indicates an extreme from what was a considered normal price action.
When price is at the channel, that is an alert to look for a pullback in the price to an area around the 20 period EMA.
This chart shows a down trending market in play.
Highlighted by the orange color, you can see that price has traveled outside of the channel. This is the first sign that we may have a trade if the pullback fits other criteria. In certain charting packages, you can set an alert that will signal you if/when price has hit the channel and some of you may find that useful.
Not all excursions equaled a pullback into the zone around the moving average and as you can see that at times, price traveled along the channel. That issue will be covered in a later trading tips segment.
We now have three definite pullbacks that met our criteria of:
- Excursion outside of Keltner Channel
- Pullback to area of 20 EMA. A price cross of the average does not invalidate the trade setup.
- Obvious trending market as shown by the slope of the channel and moving average.
Confluence and Trade Triggers
Our potential trade is now being setup but we still don’t simply enter when price touches the 20 EMA. We would like to see price pulling back not only to the mid-line but also to a price structure or exhibiting a topping pattern. This is called confluence and can actually increase the probability of your trade getting some traction.
This chart is a factor 4 less than the previous chart. By using a smaller time frame to get into the trade, you may be able to get a better position sizing as you position yourself higher in the curve to the downside in this example.
The black dotted lines on this chart are boxing off structures of possible resistance that coincide with the pullback to the mid-line. Let’s call these potential resistance zones because when price is pulling back, we don’t know with 100% certainty if price will stop at these areas but it potentially could.
These potential zones of trading opportunity that includes the structure are from the trading chart and I encourage you not to use the trigger chart to find the structure.
The trigger chart is only used for exactly what the name implies.
Before continuing, the area marked three may have some questions. It is a sloppy complex pullback because the second leg did pierce the bottom of the first before reversing from what may be considered a double bottom.
Where this gets interesting is the second leg matches in distance the first leg of the move. This is called symmetry and many traders will utilize this as a stand alone trading system. Price also exhibits a topping pattern, a double top and you can see from this chart that a confluence of factors were in play when price broke solidly to the downside.
I am using standard trend-lines to show the counter-trend move in price which brings us to our setup zone. You may use a standard break of the trend-line for your trade entry.
Stop placements could go either above the turn or above the zone that has acted as resistance.
How To Set Profit Targets When Using Keltner Channels
We are going to use the setup chart for targets and like trade entries, you have a few options.
Some traders like to target opposing structures while others would like a more objective means to find profit targets.
I’ve spoken about Fibonacci many times over the years and have shown examples from my own trading. Fibonacci was my original method of trading when I first started and have since refined things since the early days.
The fact that we are trading pullbacks makes it easy to find our targets with Fibonacci in a way that is completely objective. We are going to take the move into the extreme of our pullback and project forward in time to a potential price target.
The diagram on the chart shows that “A” is the anchor point and you pull the Fibonacci retracement tool to “B”. You project your targets at “C.”
Here are the numbers that I personally use and will use for this example. Note that 200 is omitted but I use it for targeting after a range.
- I used the bottom of the structure range for the entry price.
- I use .786 as the stop price once price breached the low of the swing leading to the extreme
- Whatever target price hit just prior to breaching the .786, it was a full exit price.
You can see the total pips for each trade in green for a combined total of 245 pips (Forex example) before spread costs. These targets are shown on the trigger chart for detail.
Use Keltner Channel Bands For Targets
If you are trading pullbacks close to the moving average or at the opposing channel line, consider taking profits or partial profits at the lower or upper channel depending on your trade direction.
In the graphic above, shorting around the moving average and using the lower band to adjust your stop or scale out partial profits is a sound trading approach. You will be using the volatility of the market to determine your price points as opposed to a subjective measure of price movement.
Complete Trading Plan
This Keltner channel trading system is not complicated but don’t be misled by the simplicity. You still have to put in the work in determining the overall trend direction, when counter trend trading is appropriate, extent of excursion plus the very important account management and risk profiles.
That’s just to name a few variables.
There are also other trading opportunities that Keltner channel trading may provide and I will cover some of those in a later post.
A lot of work goes into designing a full trading plan including back testing and forward testing. Contact our trading coaches and see how Netpicks can help you on the road to successful trading.
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