Keltner Channels are a popular technical indicator that is used by day traders for analyzing the current trend and also providing trading signals.
The Keltner Channel was discovered and named after American grain trader Chester W. Keltner, who wrote it in his book entitled “How to Make Money in Commodities” in 1960.
This is a volatility-based indicator and uses average prices to plot upper, lower, and middle lines. All three lines move along with the price and create a channel-like appearance.
Keltner Channels are volatility as well as trend following indicator that is used for identifying reversals with channel breakouts.
In this blog, we will discuss the basics of the Keltner Channel and how to use it when trading in the stock market:
What is Keltner Channel?
The Keltner Channel is a volatility-based indicator that consists of three separate lines.
The middle line is an exponential moving average (EMA) of the price. The upper and lower bands are set two times the Average True Range (ATR).
The default period of the middle EMA is usually 20 periods.
Prices usually move between the upper and lower bands which are known as the channel.
The direction of the channel or angle helps in identifying the direction of trends, so when the channel is up then the price is rising, and when the channel is downward then the price is falling.
Keltner Channel Formula:
Below is the formula for calculating the Keltner Channel Bands:
Upper Band = EMA + (ATR x multiplier)
Middle Band = EMA
Lower Band = EMA – (ATR x multiplier)
The EMA period can be set for any period i.e., according to the trader’s strategy. Usually, for day trading, an EMA is set for 15 to 40 usually.
The ATR common multiplier is 2, which means that the upper band is plotted 2 x ATR above the EMA, and the lower band is plotted 2 x ATR below the EMA.
The multiplier can also be set based on the asset you’re trading. While 2 is used often, traders can also use 1.7 or 2.3.
One should remember the higher the multiplier, the wider will be the channel; whereas the smaller the multiple, the narrower will be the channel.
How to trade with Keltner Channel?
Indicators that are based on channels or bands usually analyse the price action.
Thus, when the prices move above or below the channel lines then it attracts attention as they are relatively rare.
When the prices move above the upper channel line then it shows extraordinary strength, on the other hand when the prices move below the lower channel line then it shows extraordinary weakness.
Such strong moves above or below the channels can signal the end or beginning of the trend.
As the middle line is an exponential moving average, Keltner Channels are also a trend following indicator and lag price action.
The direction of this indicator indicates the direction of the price movement. Usually, there is a downtrend when the channel moves lower, and an uptrend occurs when the channel moves higher.
When the trend is flat then the channel moves sideways.
When the channels reverse up and break above the upper trend line, then it indicates the start of an uptrend.
On the other hand, when the channels reverse to down and break below the lower trend line then it indicates the start of a downtrend.
Sometimes a strong trend does not take hold after the breakout and prices oscillate between the channel lines indicating consolidation.
Difference between Keltner Channels and Bollinger Bands:
There are mainly two differences between Keltner Channels and Bollinger Bands.
Keltner Channels are smoother than the Bollinger Bands as the width of the Bollinger Bands is more volatile than of the Keltner channels as Bollinger Bands are based on volatility and Keltner channels are based on Average True Range.
As the middle band of the Keltner Channel is based on an exponential moving average, it is considered to be more sensitive than the simple moving average which is used by the Bollinger bands.
Bottom line:
One should note that while Keltner Channels help in identifying the trend direction, and indicate trade signals, they are best used with other price action analyses, fundamentals for the long term, and other technical indicators.
Happy Investing!
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