Keltner Channel - the perfect channel indicator
Hello friends forex traders!
The Keltner channel is an envelope of moving averages formed around the EMA and tied to the volatility of the instrument. This indicator is very similar to Bollinger Bands, which uses standard deviation to change the channel width. Instead of the standard deviation, the Keltner Channel uses the indicator Average True Range, or ATR (Average True Range).
The Keltner channel is a trend indicator used to search for reversals in the breakdown of its borders. And today we will analyze the features of this indicator, and also see how it can be used in trade.
Description of the indicator The Keltner Channel first appeared in 1960 in Chester Keltner's book, How to Make Money in Commodity Markets. Initially, this was the Ten Day Moving Average Trading Rule. The first version of the Keltner Channel was built around a ten-day simple moving average, calculated at a typical price ((High + Low + Close) / 3) as the center line. To build the channel, a ten-day distance between the maximum and minimum points was used - that is, the difference between the maximum and minimum prices for 10 days.
Then, already in 1980, the well-known algo trader, founder and president of LBRGroup Linda Raschke, presented to the public a modernized version of the Keltner Channel, where the ATR indicator was already used to calculate the channel width.
Another talented trader, Robert Colby, advised taking the bar closure as a cost and applying a modification of Linda Raschke along with an exponential moving average (EMA). That is how we know this wonderful indicator in our time.
All indicators based on channels, envelopes, bands are created for the analysis of trend movements. However, if the price is outside the bounds of such an indicator, this is a rather strong signal, since it does not happen often. The fact is that trends usually begin with a sharp strong movement in one direction or another and a strong breakdown of the channel can serve as a signal for the emergence of a new trend.
The Keltner channel is a trend indicator, and, like the moving averages laid in its foundation, has the property of decently lagging behind.
Despite its nearly hundred-year history, this indicator has been unfairly forgotten by the developers of the most popular MetaTrader 4 terminal on the Forex market. But this is not scary, because you can download any one to your taste on the pages of our forum.
The settings sometimes differ depending on the particular implementation of the indicator, but, as a rule, this is the period of the exponential moving average, which sets the center line of the indicator, as well as the period and multiplier of the ATR indicator to plot the indicator boundaries.
Indicator calculation and parameters
The Keltner Channel indicator can be calculated in three steps. First, we calculate the exponential moving average, then ATR, and then we add or subtract from the reading the ATR value multiplied by a certain coefficient.
Middle Line: 20-day exponential moving averageUpper Channel Line: 20-day EMA + (2 x ATR (10))
Lower Channel Line: 20-day EMA - (2 x ATR (10))
The larger the period you take for the calculation, the stronger the indicator will lag. The larger you take the coefficient for ATR, the more difficult it will be for the price to break through the channel boundary. Changing the coefficient from 2 to 1 will halve the channel width. Here is a chart with odds 1, 2 and 3:
By default, deviation 2 is usually used, in the figure above it is highlighted in green. A wider channel with a deviation of 3 is indicated by blue and a narrower channel with a deviation of 1 is red. All three channels are built on the EMA20 using ATR10. The higher volatility a currency pair has, the wider channels are formed.
Now that you have familiarized yourself with the formula, you are well aware that the borders themselves can be made more volatile by decreasing the ATR period and more, for example, by widening by increasing the ATR multiplier.
Comparison with Bollinger Bands
As you can see, the indicator is very similar to the Bollinger Bands, but there are still some differences.
Blue indicates the Keltner channel (KC20 (dev2, ATR20)), crimson - Bollinger bands (BB20 (dev2)). As you can see, the main difference is that, firstly, the Keltner channel is smoother, since the bandwidth is based on the Standard Deviation indicator, and its readings, in turn, are more volatile than the indicator ATR Many traders consider this a plus, as the borders are "more permanent." This makes the Keltner indicator more suitable for trend following strategies and for trend identification. Secondly, the Keltner channel is built around an exponential moving average, which has a higher sensitivity than the simple moving average, which is used to build Bollinger bands.
Keltner Channels Trending Application
The indicator author himself advises that seasonality and cyclicality be taken into account when using this indicator. According to him, many instruments have certain seasons when good trend movements are most likely. Therefore, Chester advises, as far as possible, to take this factor into account in his trading and use seasonality as a filter for entry. Naturally, Keltner had in mind seasonality on the daily charts.
When working on a trend, you should clearly see that the upper and lower boundaries are trending towards the planned transaction. Same thing with moving average. By the way, this rule is used in many trading systems. For example, a twenty-day midline slope is taken into account in the already pretty forgotten Forex Gambit strategy. According to the classical rules, we must trade between the upper border and the center in an uptrend, and the lower border and center in a downtrend. In this case, of course, the entrance to the transaction should occur during a rollback to the middle line.
At the same time, experienced traders also pay attention to candles - the price should either touch the middle line when rolling back, or be very close to it. Breakdown of the opposite channel is allowed, but no more than ½ of its width, but such an entrance is considered quite risky. Also, candles at lower periods should show a reversal in the direction of the transaction.
The outputs are usually carried out at the borders of the channel. Let's illustrate this approach:
Rectangles indicate possible places to enter positions; arrows indicate the channel slope and, accordingly, the direction of the trend. Asterisks indicate the expected exit points in profit, and crosses in losses. As you can see, profitable deals prevail in trending areas.
Using the Keltner Channels indicator to work in a channel
Another option for using the indicator is to work inward to return to the central moving average, that is, from the borders of the channel. This type of trading appeared later than the emergence of trend trading, and initially the Keltner channel was created as a trend indicator. Nevertheless, this fact does not prevent it from being used in strategies of "returning to the average." As a rule, in this case, oscillator readings, mainly CCI, RSI and WPR, are used for additional confirmation of signals. Stochastic Oscillator is a little less common.
By and large, the algorithms for calculating oscillators are similar, and the main differences arise in the degree of smoothness, sensitivity to price changes and the rate of change of readings. Therefore, which of the oscillators to use remains a matter of personal preference. Somewhere there are more signals, somewhere less, some more accurate, others less. The optimal oscillator on one pair of a certain timeframe may be, for example, WPR, on the other - RSI.
Therefore, of course, it is worthwhile to select a pair for the Keltner channel based on tests on historical data. It is worth noting that trading for a return to the average is more effective in quiet periods of lateral movements, while trading from the center line of the channel, taking into account its slope, works better during periods of a stable trend.
Also, I often met recommendations to switch to working on a trend if ADX is above a certain value, usually 20-30, and to work in the channel at values below this value.
Keltner Channels Breakdown Application
The third way to trade on the Keltner Channels indicator is as follows:
A narrower coefficient for ATR is taken (in this case 1), then work is performed on the breakdown of the boundaries of the Keltner channel, provided that it slopes towards the breakdown. An exit, as a rule, is carried out either at the center line of the channel, or approximately in the middle of the band, without waiting for the price to approach the center line. A more risky approach involves entering immediately at the close of the candle outside the broken channel, but cautious traders prefer to place pending orders just above / below the High / Low signal candle.
You can also apply other exit tactics - with a moving stop, according to the signals of other indicators, and so on. For filtering, the ADX indicator is sometimes used, making sure that its readings at the time of breakdown are not lower than a certain value, usually 40-50. This type of trade is characterized by a series of small losses when the market is calm and large, but not frequent, profits.
As a rule, profits exceed losing trades by 5-10 times, but the percentage of profitable trades is quite small - below 50%, often about 40%, sometimes you can even meet 30%. Psychologically, trading in this way is very difficult, because you do not know in advance where you will find another profitable trade that will pay off all previous minor losses and bring long-awaited profits. We discussed this issue in detail in this article.
Like any other channel indicators, the Keltner Channel has the same positive and negative sides, just some of them are less pronounced. Nevertheless, the Keltner channel is an excellent trend indicator, originally developed specifically for the strategy of entering trend transactions after pullbacks.
The indicator is very old and during its existence acceptable strategies have been formed for both the trending markets and markets moving sideways. And this makes the Keltner channel a rather universal tool, especially when correctly combined with other indicators and candlestick patterns.