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How to Day-Trade With Keltner Channels
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.
Keltner Channels are a combination of two other indicators: the exponential moving average (EMA) and the average true range (ATR).
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.
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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.
Keltner Trading Strategy – Three Proven Ways for Success
Learn the three proven techniques you can use every day to trade with the Keltner trading strategy. The Keltner channel system can improve your profitability because it adapts to the ever-changing Forex market conditions.
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In this detailed step-by-step trading guide, you’ll learn about the Keltner channel indicator. We believe it can help you become a profitable trader. First, you’ll learn some background information about the Keltner Channel to make more informed trading decisions.
This amazing indicator works best when used in conjunction with other technical indicators and/or chart analysis.
Now let’s learn how to trade with Keltner channels indicator and how it can help you trade in different market conditions.
How to Trade With Keltner Channels
Keltner Channel is a technical indicator that belongs in the envelope indicators family. An envelope indicator, when plotted on a price chart, will display an upper and lower band. This creates a dynamic channel that contains the price range inside the two bounds.
*Note: The price has the tendency to trade outside the Keltner channel boundaries. This often happens in the presence of a strong trend.
The Keltner Channel is a volatility-based indicator that is comprised of a simple exponential moving average. Around it, we have a lower band and an upper band that is based on a setting that you use.
Our preferred Keltner channel parameters use a 20-period for the middle exponential MA with a multiplier of 2 for the extreme bands.
The Keltner Channel will assist you to objectively measure the market volatility, assess the current trend, spot potential breakout trades, trade pullbacks, and trend reversals. You can also use scalping techniques with the Keltner Channel if you want to be in and out of a trade quickly.
Basically, the channel created provides an envelope for the price that very similar to the Bollinger Bands indicator. The difference between the two is that Keltner Channels are based on ATR (Average True Range) while Bollinger Bands are based on a standard deviation.
If you want to get more technical and understand the math behind this volatility indicator, see the formulas below:
- Middle Band = 20-Period Exponential Moving Average Value
- Upper Envelope= 20-Period Exponential Moving Average Value + Multiplied Value of Average True Range (ATR)
- Lower Envelope = 20-Period Exponential Moving Average Value + Multiplied Value of Average True Range (ATR)
How to correctly interpret the Keltner volatility indicator.
During the time periods when the price kind of hugs the upper envelope and the upper band also points upwards, this is a signal of a strong bullish trend. In other words, the price continuously crawls along with the upper band.
Note #2: The same is true in reverse, in which case the volatility indicator signals a bearish trend.
When the Keltner bands are flat and move horizontally, this trade signals the presence of a ranging market. In this case, the price tends to bounce between the upper and lower envelope without showing any clear directional bias.
Another practical trading application derived from the Keltner channel indicator is the ability to measure retracements. Keltner channel indicator is a good source of information when it comes to pinpointing the end of a pullback.
In the presence of a strong upward or downward trend, pullbacks tend to stall near the middle 20-period EMA.
Now, before we go any further, we recommend taking notes over the rules of this scalping strategy.
In this article, we’re going to look at the buy-side .
Keltner Channel System
The Forex market has a natural rhythm that goes from a trending market to consolidation and vice versa. However, you also have to deal with different types of volatility that changes constantly. That’s where the Keltner Channel system can help you be a more proficient trader.
The Keltner Channel indicator is a really great tool, but it tends to perform better when used in combination with other technical indicators.
Moving forward, we’re going to explore how you can combine the Keltner indicator with other tools and at the same time to suit the market environment you’re in.
We’re going to explore three typical examples where you can use the Keltner trading strategy.
Trading Breakouts with Keltner Channel
When it comes to breakout trading, the Keltner Channel is a very powerful indicator. The Keltner Channel breakout system works best when volatility rises. However, the Keltner indicator measures not just the volatility, but it can also show anomalies in the price behavior.
Since the Keltner channel indicator is lagging in nature, we can use a secondary tool like the ADX indicator to give us more confluence. These two indicators can help us catch explosive breakouts.
With the ADX we measure the strength of the breakout. Generally, an ADX reading above the 20 level is considered to be the beginning of a bullish/bearish trend. Any reading below 20 signals is a period of consolidation.
The ADX needs to continue to rise to suggest that the trend is strong. When the Keltner Channel is used in combination with the ADX indicator, you can trade breakouts with objectivity.
Trigger conditions for buying breakouts:
- Keltner Channel bands need to turn flat.
- Price needs to break above the upper band.
- ADX needs to cross above the 20 level.
Follow the above trading rules if you want to avoid most of the false breakouts.
Trading Ranging Markets with Keltner Channel
It is said that the number one account killer in the market is a ranging market. Consolidations are very difficult to trade. However, you can take advantage of the difference in the way the Keltner channel system can be used in combination with other technical indicators.
The price won’t really touch the bands when it bounces between the upper and lower envelopes. When we’re in a ranging market, you’ll often see that the price will fail to touch the bands. The majority of the time the price will hug the middle band.
This anomaly in price behavior requires us to use a secondary technical indicator to find profitable trades.
Since the Forex market spends most of its time in consolidation (around 70% of the time), it’s mandatory to have a range trading strategy to survive in this market.
For range trading, we like to use Keltner Channel bands in combination with a 2-period RSI indicator. We tweaked the RSI settings so we can better identify tops and bottoms within a trading range.
*Note #3: For this Keltner trading strategy we use the 90-10 levels of overbought and oversold readings.
Here are some rules that can guide you to make the best trading decisions:
- Keltner envelopes need to turn flat, to signal a consolidation.
- The price needs to break below the middle band.
- A buy order is triggered once the 2-period RSI goes below 10 indicating oversold conditions.
- The protective stop loss can be hidden on the other side of the Keltner band.
- For the long side take profit when the RSI reaches the 90 levels.
Trading Pullbacks with Keltner Channel
Trading pullbacks successfully can only be done in the presence of a strong trend. Using the Keltner channel indicator we can study how the price behaves around the upper and lower envelopes to gauge the strength of the trend.
As you already learned when the price hugs one of the two bands and crawls along with the band, we have a case for a strong trending market.
In the chart below we’ve highlighted small retracements while the price hugs the upper Keltner band. Notice that the price retrace to the area around the 20-EMA. It won’t give you an exact price, but a price zone from where the price can potentially bounce and the bullish trend can resume.
This is a good way to measure pullbacks in price. Successful trading doesn’t require catching the exact turning point.
For a better timing of our trades, we can use the Stochastic RSI indicator in combination with the Keltner indicator for more confluence.
The trade trigger is simply to follow with this Keltner Channel pullback strategy. Pull the trigger when the price retraces to the middle band and the stochastic indicator develops a crossover from oversold territory.
Conclusion – Keltner Channel System
Knowing what type of market environment you’re in can help you decide what technical tools to use. Designing a trading strategy to suit all types of market environments requires a lot of work and backtesting. With all honesty, that’s very hard to accomplish and that’s the reason why we encourage you to learn how to trade with Keltner channels in combination with other tools.
Once you understand the power of Keltner channels and how to properly combine it with other technical indicators, a new realm of trading opportunities will emerge. This amazing indicator comes with most trading platforms, but even if you can’t find it in the indicator library, you can still opt to use a third-party developed Keltner channel indicator.
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Effective Keltner Channel Trading Strategy
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.
Keltner Channel is used to measure the volatility of a market using ATR and upper and lower channels
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.
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.
Channels can show deviation from normal price behavior
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).
Keltner Channel and Moving Average
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.
Bollinger Bands VS Keltner Channel
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.
Price moves to channel extreme
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.
Valid and invalid price excursion to channel extreme
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.
We need a trigger to get into the trade and there are many tools that you can use. Momentum indicators are a popular method as well as the very basic trend line.
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.
Trend lines and Keltner Channel trading strategy
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.
Fibonacci profit targets
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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