Keltner Channel is an indicator of market volatility, which, like the Bollinger bands, creates a channel around the moving average and in which prices tend to remain included.
The Keltner Channel indicator is named after its inventor, Chester W. Keltner. It is a volatility-oriented channel that measures price movements about the minimum and maximum moving average bands.
Chester Keltner was a commodity trader and was the first to formulate this theory.
Among the tools available to traders to measure the volatility of an asset, the most famous is undoubtedly the Bollinger Bands and the Average True Range (ATR).
The Keltner Channel Indicator, like the Bollinger bands, builds a channel around the moving average, thus creating a sort of “road” within which prices usually travel.
Then when there are explosions of volatility, prices come out of the bands, and that’s what triggers an operational trading signal.
The theory behind the Keltner Channel Indicator in a nutshell is:
We must mark the bands at a certain distance from the average market price.
The bands are far enough apart to represent a significant market movement.
If the market moves within these bands, there is a higher than average probability that we will see prices continue the trend in that direction.
Variations tend to revolve around the specifications of where to place the bands. The basic calculation is:
- Midline: Exponential moving average at 20 days.
- Upper channel line: 20 days EMA + (2 x ATR(10)
- Lower channel line: 20 days EMA + (2 x ATR(10)
We must bear in mind that prices are maintained in the area between the top and bottom lines for most of the time. If, on the other hand, these prices exceed the established limits, they gain upward or downward force.
How to use the Keltner Channel Indicator
From an operational point of view, the Keltner Channel Indicator is often used in a trend-following logic. The logic is to open up bullish positions if prices break the upper band upwards or downwards in the opposite case.
However, the signal will only be confirmed at the end of the session with the maintenance of the channel break. If the break comes after a period of lateral accumulation, the signal could be the beginning of a new phase of the trend.
Caution, however, because this indicator usually provides excellent indications if you are within a stable phase of the directional trend. At the same time, it could lead to false signals if prices are in a period of lateral congestion.
Buy and sell signals:
BUY SIGNALs: in case prices break and close with a candle over the top of the channel. If the break comes after a period of lateral accumulation, the signal could be the beginning of a new phase of the trend.
SELL SIGNALs: if prices break and close beyond the lower band. If the break comes after a period of lateral accumulation, the signal could be the beginning of a new phase of the trend.
Keltner Channel and Bollinger Bands – Differences
Bollinger Bands are one of the most used tools by traders in their business and involve the use of dynamic channels that aim to contain and accompanying prices.
These bands are constructed on a central moving average, usually over 20 periods, and two fluctuation bands, one upper and one lower, are calculated based on price volatility.
In a very similar way, the Keltner Channel performs the same function. The substantial difference between the two indicators is their composition and reaction to price movements.
The indicator designed by Chester Keltner develops around an exponential moving average, unlike Bollinger bands that use a simple moving average. In contrast, the two upper and lower oscillation bands are calculated based on the Average True Range (ATR).
The ATR is the average value between the maximum price, the minimum price, and the closing price of the financial instrument.
Having set the exponential moving average and calculated the ATR, I will obtain the two oscillation bands by merely applying the formula EMA + (2xATR) for the upper band and EMA – (2xATR) for the lower band.
The difference we can see is that the Bollinger bands exploit the volatility of the market while Keltner Channel is built on an average price resulting from a mathematical formula.
This difference means that Keltner Channel is more linear than the Bollinger bands, i.e., it suffers less from price fluctuations giving fewer false signals due to high volatility.
The moving averages used by the two indicators are also different. Keltner Channel Indicator uses the exponential moving average, while Bollinger’s bands use the simple one.
Exponential, by placing more weight on the most recent prices and less on those furthest away in time, is considered more reliable because it is more sensitive to price movements.
This channel is less prone to computation errors than the Bollinger Bands.
Crossing the upper band or moving average can be seen as a continuation signal. Also, both the midline and moving average are strong candidates to establish our stop loss line.
The use of ATR produces more fluid movements; we will avoid sudden changes that can influence our strategy.
The Keltner Channel Indicator is reliable and easy to interpret.
It is a little-known indicator and, therefore, very reliable. It is therefore highly advisable to use it. If many traders use the indicator, the market may be affected again.
On the other hand, reading the Keltner Channel Indicator is very intuitive, so you don’t need to have a sixth sense or specific preparation to understand how they work.