The Keltner Channel is a lesser-known indicator but deserves a wider appreciation than it gets. It can be used to effectively identify either trending or ranging market conditions as well as good points for trade entries. In this article, you will see how the Keltner Channel indicator works and how it can best be used by traders.
What are Keltner Channels?
A Keltner Channel is a technical indicator that can be applied to a Forex price chart or any other kind of price chart. A Keltner Channel is extremely similar to a Bollinger Band, so if you understand what Bollinger Bands are and how they are calculated, it shouldn’t be difficult for you to get to understand the Keltner Channel. If you aren’t intimately aware of the Bollinger Band indicator, what you need to know is that a Keltner Channel is calculated as an envelope of volatility around an exponential moving average (EMA). Typically, the 20-period EMA is used. When drawing a Keltner Channel, the center line of the channel is a moving average, and the upper and lower bands which are drawn equidistant from the moving average both above and below it are simply based upon a multiple of the measurement of the volatility of the price, based upon the Average True Range (ATR) indicator, traditionally set over ten periods.
The only two differences between the Keltner Channel and the Bollinger Band are that the Bollinger Band’s upper and lower bands are drawn by a measurement of standard deviation from the central moving average as opposed to the Keltner Channel’s ATR, and that the central line of the Bollinger Band uses a simple moving average (SMA) while the central line of the Keltner Channel uses an exponential moving average (EMA). Standard volatility tends to fluctuate much more dramatically than average true range, so a Keltner Channel tends to be smoother over time than a Bollinger Band. To give you an idea of what a Keltner Channel looks like and how it compares to a Bollinger Band, the chart below shows both indicators applied to the same price series, with the Bollinger Bands in red and the Keltner Channel in blue. The width of the Keltner Channel is twice the 20-day ATR while the width of the Bollinger Band is twice two standard deviations.
It is immediately obvious from looking at the above chart that there is only a relatively small difference between Bollinger Bands and Keltner Channels, so arguably, it makes little practical difference which of the two indicators are used.
Now that you understand how a Keltner Channel is calculated, it is time to look at a few easy rules you can use to interpret a Keltner Channel indicator drawn on a price chart.
Interpreting a Keltner Channel
Here are a few hard and fast rules of thumb you can use to interpret a Keltner Channel on a price chart:
If the bands are relatively narrow, volatility is relatively low.
If the bands are relatively wide, volatility is relatively high.
If the channel is sloping up, there is an upwards trend over the period which the EMA at the center of the channel is set to.
If the channel is slowing down, there is a downwards trend over the period which the EMA at the center of the channel is set to.
If the price is above the upper edge of the channel or very close to it, and the channel is sloping upwards, then the upwards trend is active and aggressive.
If the price is below the lower edge of the channel or very close to it, and the channel is sloping downwards, then the downwards trend is active and aggressive.
Now let’s look at how these rules can be applied in more detail to the use of this trading tool. All trading is made on the basis of at least one of two concepts: either that the price is trending / moving with momentum and likely to continue in the same direction, or that the price is about to reverse and go back to where it recently came from, i.e. revert to its mean (average). In both cases, traders want to enter trades in places where the trade is more likely to go further in one direction than the other. Let’s look first at how a Keltner Channel can be used to trade with the trend.
Trend Trading with a Keltner Channel
In trend trading with a Keltner Channel, the first step is to use the indicator to determine whether a trend currently exists, and in which direction. This can be ascertained easily: is the channel sloping up, sloping down, or neither. If there is a slope, it indicates the existence of a trend, and the trend’s direction. The longer period the indicator has been sloping in the same direction for, the more persistent the trend, and the steeper the slope, the stronger the trend.
Now we have identified the trend as an entry filter, what about the entry? There are three common approaches:
Enter in the direction of the trend when the price is beyond the outer limit of the channel.
Enter in the direction of the trend when the price is between the center line and the upper limit of the channel.
Enter in the direction of the trend when the price is touching the center line of the channel.
We can test the efficacy of these approached by back testing each method against historical data. In this case we’ll use daily data between 2001 and 2019 for the two most common Forex currency pairs, EUR/USD and USD/JPY, and apply a 20-period Keltner Channel at the standard settings. Our back test assumed a spread on every trade of 1 pip and were normalized for volatility by the 15-day average true range. The results for trades where the price closed completely beyond the Keltner Channel’s outer edge were as follows:
Number of Trades
The result for trades where the price closed within the Keltner Channel but with direction determined by the position of the center line were as follows:
Number of Trades
These results tell us that there was a small but meaningful positive trading edge, although a narrow majority of most trades were losers. On average, the next day’s candle went in the direction of the trend by between 2.51% and 4.11% more than it did against it, and a time-based exit at the next day’s close was also profitable. The edges grow if the trades are left to run for a longer period.
Mean Reversion Trading with a Keltner Channel
In mean reversion trading with a Keltner Channel, we identify that a flat, trendless channel condition exists. This is best achieved by using two Keltner Channels with the same settings, but with one applied to a shorter time frame and the other applied to a longer time frame. The shorter time frame should show a trend in the opposite direction to the trend on the longer-term time frame. The most common approach as an entry method is to enter towards the direction of the center line when the price is beyond an outer limit of the shorter-term channel, while the longer-term channel is sloping in the opposite direction.
The Keltner Channel is a useful tool for illustrating prevailing conditions of trend and volatility on a price chart and can be used as a standalone indicator to facilitate profitable trading. Like many indicators, it is most powerful when applied at the same settings to multiple time frame charts for the same instrument.
Original from: www.dailyforex.com