What Are Keltner Channels?

07 May 2021

    What Are Keltner Channels?

    Keltner Channels is a statistical chart indicator used for financial technical analysis. Keltner Channels were  introduced by a grain trader named Chester Keltner in his 1960 book, How To Make Money in Commodities. Keltner Channels is a technical analysis indicator, used by traders in manual trading and automated strategies, and its main purpose is to provide information about price and volatility of the underlying symbols like stocks, currency pairs and crypto assets. You can find the Keltner Channels indicator in all popular trading platforms offered by any CFD broker, including Fondex cTrader. In this article we will explain how Keltner Channels are calculated, what they represent, and how they are used in different trading strategies, like trend, price break out and mean reversal strategies, with examples taken from Fondex cTrader charts.

     

    Calculation of Keltner Channels 

    Keltner Channels are composed of three lines (bands) plotted on the chart. These lines are 

     

    Middle Band - A moving average of the price, usually the exponential moving average of the candlesticks closing prices.

    Upper Band -  Moving average  +  n-times average true range.

    Lower Band - Moving average  -  n-times average true range.

     

    In the chart below we can see a typical Keltner Channels indicator plotted on a candlestick chart in Fondex cTrader.

     

     

    In greed we can see a twenty-period exponential moving average of the closing prices, and in red and blue - the relevant upper and lower Keltner Channels Bands, respectively. We can notice how Keltner Channels Bands get wider when there is volatility in the market, and how they become narrower when the market is relatively quiet. A typical setup for the Keltner Channels Bands indicator is a 20 periods exponential moving average and an average true range of 10 periods and 2 standard deviations, as shown below

     

     

    Fondex cTrader further allows you to shift the indicator back and forth, as well as to choose a different type of moving average.

     

    What Do Keltner Channels Tell You?

     

    Keltner Channels are used in a similar way to Bollinger Bands, which is to indicate the levels at which the price can be considered too high or too low, taking into account the average market price and market volatility at the given moment. The difference between the two indicators is the fact that Keltner Channels use the average true range to form the relevant bands, instead of standard deviation. However the interpretation of the two indicators is similar. When approaching or crossing the bands, the price starts deviating from the typical price range. In other words, when the market price approaches the upper Keltner Channels Band, then the market can be considered overbought, and when it approaches the lower Keltner Channels Band, it can be considered oversold. The average true range bands indicate the range in which the prices can be considered normal. When the price approaches or crosses one of the bands - trades are justified to expect something to happen, usually a breakout to a new trend or a bounceback. 

     

    The Keltner Channels indicator does not provide any trading signals on its own. It just describes the current state of the market, whether is volatile or not, trending or ranging, and it is used by traders in context with other available information to determine the possibility of future price movements. Hence, there are different strategies based on Keltner Channels, which combine other information to determine the possibility of future price movements. Below we present and explain a few of them.

     

    Keltner Channels Strategies

     

    Keltner Channels are used successfully in several trading strategies. In the following paragraphs, we will outline some of the most popular ones, and explain how you can use them in your trading.

     

    Bounce Strategy

     

    The bounce strategy is based on accepting the markets’ mean reversion theory. In brief, the mean reversion theory states that the price of a stock, index, currency pair on any other instrument will tend to move to the average price over time. In the Keltner Channels context, this means that if the price is trading near the bands, there is a possibility of a reversal to the moving average after some time. In this case, the bands work as dynamic support and resistance levels. See an example of prices bouncing back to the moving average after reaching the upper end lower Keltner Channels below.

     

     

    We see that even though prices touched the upper and lower Keltner Channels, eventually they returned to the moving average. However, the fact that the instrument price is near or has broken the bands resistance is not reason enough to expect the price to bounce back. Betting only on prices bouncing back to average might lead to a lot of false signals since the return to the moving average cannot be guaranteed. Below we use the same chart to highlight cases where the price touched the upper Keltner Channels band, but continued to an upwards trend, without ever returning to the moving average, resulting eventually in a false bounce back signal. 

     

     

    The reason this happened is because the bounce strategy does not work well in markets in trend, but is rather more appropriate for ranging markets. In the chart above, however, EUR/USD was clearly in an upward trend. If you plan to use the bounce strategy in a trending environment, make sure you are placing trades only in the direction of the trend since betting against the trend might be very risky. In the chart above, all buy trades, in the direction of the buy trend, would have had a profitable outcome. Most sell entries on the other hand, would have had a devastating one, since they go against the dominant trend.

     

    Squeeze Strategy

     

    Another way for using the Keltner Channels is the identification of a price breakout and the formation of a new trend. A popular strategy for identifying the creation of such a trend is the Squeeze strategy. The Squeeze strategy says that when there is a prolonged squeeze of the Keltner Channels Bands around the price movement, indicating the indecisiveness of the market, then a break out and the formation of a new trend is possible as soon as the price breaks one of the support/resistance lines, marked by the upper and lower Keltner Channels Bands. 

     

    In the EUR/GBP chart below we identify a prolonged squeeze of the price and demonstrate a successful identification of a breakout, following the Keltner Channels Bands squeeze.

     

     

    As we can see from the chart, the price was fluctuating around a moving average for a prolonged period of low volatility, without a specific trend being present. As soon as the price broke the upper Keltner Channels Band, prices moved rapidly upwards, forming the beginning of a new trend. If we entered into a long position at the point where the price broke the upper Keltner Channels Band, we would have made some nice profits. This is a successful use case of the Keltner Channels Band Squeeze strategy.

     

    Limitations of the Keltner Channel

    Keltner Channel, as any other technical indicator, always needs to be used in context. An out of context interpretation of the Keltner Channels patterns can generate a lot of false signals that could lead to substantial losses. Therefore, when using the Keltner Channels indicator, always consider the market fundamentals that currently move the market and combine the signals with other confirmation signals, like trend indicators, support/resistance levels and the relevant price action taking place on the chart.


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