Keltner Channels are a popular technical indicator that day traders can use to help assess the current trend and provide trading signals. The channels use volatility and average prices to plot upper, lower, and middle lines. All three of these lines move with the price, creating a channel-like appearance.
Calculating Keltner Channels
Keltner Channels were introduced by Chester Keltner in the 1960s, but the indicator was updated by Linda Bradford Raschke in the 1980s. This later version of the indicator is the one in use today.
The moving average is the average price for a certain number of periods. The exponential variation gives a greater weighting to more recent prices and a lesser weighting to prices that aren't as recent.
The average true range is a measure of volatility that was created by J. Welles Wilder Jr. and first introduced in in his 1978 book "New Concepts in Technical Trading Systems." The true range for a given day is the greatest of the following: the current high minus the current low, the absolute value of the current high minus the previous close, or the absolute value of the current low minus the previous close. The average true range is then a moving average, generally over a period of 14 days, of the true ranges.
Here is how Keltner Channels are calculated:
Upper Band = EMA + (ATR x multiplier)
Middle Band = EMA
Lower Band = EMA - (ATR x multiplier)
The EMA period can be set to anything you want. For day trading, an EMA of 15 to 40 is typical.
A common multiplier for the ATR is 2, meaning the upper band will be plotted 2 x ATR above the EMA, and the lower band will be plotted 2 x ATR below the EMA.
The multiplier can be adjusted based on the asset you're trading. While 2 is common, you may find 1.7 or 2.3, for example, provide you with better information for the exact market you trade. The higher the multiplier, the wider the channel; the smaller the multiple, the narrower the channel.
Correctly Adjusting the Indicator
Keltner Channels are useful because they can make a trend more easily visible. When an asset is trending higher, its price should regularly reach or come close to the upper band and sometimes even move past it. The price should also stay above the lower band and will often stay above the middle band or just barely dip below it.
When an asset is trending lower, it should regularly reach or come close to the lower band and sometimes even move past it. The price should also stay below the upper band and will often stay below the middle band or just barely push above it.
The indicator should be set up so these guidelines hold true most of the time. In other words, if the price is moving continually higher but not reaching the upper band, then your channels may be too wide and you should lower the multiplier. If the price is continually trending higher but often touches the lower band while doing it, your channels may be too tight and you should increase the multiplier.
For your indicator to help you analyze the market, it needs to be adjusted correctly. If it isn't, then the trading guidelines won't hold true and the indicator won't serve much of a purpose.
The Trend-Pullback Strategy
Once the indicator is set up properly, the general strategy is to buy during an uptrend when the price pulls back to the middle line. Place a stop loss about halfway between the middle and lower band and place a target price near the upper band.
Alternatively, if you find the price is hitting your stop loss a lot (and you have already adjusted your indicator so it matches the guidelines), you can move your stop loss a little closer to the lower band. This gives the trade a bit more room and will hopefully reduce the number of losing trades you have.
Sell short during a downtrend when the price rallies to the middle line. (A short sale usually involves selling a borrowed asset with the expectation of buying it back and returning it at a lower price.) Place a stop loss about halfway between the middle and upper band and place a target near the lower band. If you find the price is hitting your stop loss a lot (and you have already adjusted your indicator so it matches the guidelines), you can move your stop loss a little closer to the upper band.
This strategy takes advantage of the trending tendency and provides trades with an approximate 0.5 risk-reward ratio since the stop loss point is about half the length of the target price length.
Not all pullbacks to the middle band should be traded. Sometimes a trend isn't present, in which case, this method isn't effective. If the price is moving back and forth between hitting the upper and lower band, then this method also won't be effective. Continually check to make sure the market is following the pattern for the trading guidelines; if it isn't, don't use this strategy.
The Breakout Strategy
The Keltner Channel breakout strategy attempts to capture big moves that the trend-pullback strategy may miss. The breakout strategy should mostly be used near a major market open. That is when the most explosive movement occurs, which favors this strategy.
The general strategy is to buy if the price breaks above the upper band or sell short if the price drops below the lower band in the first 30 minutes after the market opens.
The middle band is used as the exit. There is no profit target for this trade. Just exit the trade whenever the middle band is touched, whether the trade is a loser or a winner.
Since the market is typically volatile right after the open, you may get one signal that results in a loss or small profit, immediately followed by another signal. Trade the second signal as well. Take only two trade signals for this strategy in the first 30 minutes. If a big move doesn't occur on the first two channel breakouts, then it probably isn't going to happen.
This strategy is best applied to assets that tend to have sharp trending moves in the morning. If you notice that an asset is fairly sedated and rarely has big moves, then this is not the strategy to use on that asset. Attempting to use this strategy on an asset that doesn't have sharp and volatile moves in the morning will result in many losing trades because the price is unlikely to keep running after the breakout and will likely reverse instead.
Combining the Trend-Pullback and Breakout Strategies
The Keltner Channel day trading breakout strategy is designed for use right around the open of a major market and only in assets that tend to have sharp and sustained moves during that time. The trend-pullback strategy is more applicable throughout the day, and the only requirement for the strategy is that a trend that meets the guidelines occurs.
If you get a breakout strategy trade in the morning, that trade will end once the price reaches the middle band. At that point, you can decide if you want to take another trade using the trend-pullback strategy.
When using the trend-pullback strategy, if there were big moves in the morning but during the course of the day the price flattens out and moves in a very tight price range, then the breakout strategy may become useful again. If the price is tightly compacted, it won't offer good trend trades, but if the price was volatile earlier in the day, some of that volatility may return. Watch for a breakout above or below the upper or lower band to signal a trade and a possible return to bigger trending moves.
When using the breakout strategy during the day, the same exit rules apply; exit when the price touches the middle band. You then can decide if the trend is strong enough to warrant taking another trend-pullback entry.
While both of these strategies provide entries and exits, it is a subjective strategy in that it is up to the trader to determine the best times to implement each strategy and which trades to take. Not all trade signals for these strategies should be taken. When conditions are right for each strategy, though, they tend to work well.
You may need to adjust your Keltner Channel settings slightly if you trade different assets. The settings you use on one asset may not necessarily work, or be the best settings, for another asset.
Before using Keltner Channels to trade with real money, practice trading on the indicator's signals in a demo account. Practice deciding which trades to take and which to avoid. Only when you are consistently successful over many practice sessions should you consider trading with real capital.