The Keltner Channels indicator was created in the late 20th century for trading commodities. Since then, it has earned the recognition of traders and overgone many modifications. Now this technical indicator is used to determine the direction of the trend and find profitable entry points.
The Keltner Channel can be applied to any market and trading instrument. It has few settings and is easy to learn. In addition, it generates profitable signals and suits different trading styles. In this review we will have a look at the Keltner Channel indicator, how it works, its calculation formula, as well as the main trading strategies using this indicator: the channel breakout and the trend pullback.
The article covers the following subjects:
What Is the Keltner Channel?
The Keltner Channel is a volatility-based technical analysis indicator that helps determine the trend on the market. Like other similar indicators (Bollinger Bands, Donchian Channels, and others), it is based on channel price movement. When the indicator is applied to the chart, you see the upper and lower boundaries of the channel, within which the price will presumably stay most of the time.
The Keltner channel uses the average true range (ATR) of the instrument in its calculations. At the same time, price breakouts above or below the upper or lower border of the channel signal the continuation of movement in the direction of the breakout.
The indicator consists of the following lines:
the middle line is an exponential moving average (EMA) with a period of 20, which can be adjusted as desired;
the upper and lower lines, which are the boundaries of the channel and represent the average true range (ATR) multiplied by 2. The multiplier can also be adjusted to your liking.
Main signals and data generated by the Keltner Channel:
the price reaching the upper border of the channel signals a bullish mood on the market;
the price reaching the lower border of the channel signals a bearish mood on the market;
the direction (vector) of the Keltner channel also helps determine the direction of the trend;
the price may fluctuate between the upper and lower borders of the channel. In this case, the boundaries are resistance and support levels to trade from.
Brief History of the Keltner Channel
The author of the Keltner Channel indicator is the American grain trader Chester Keltner. He described this technique in his book How To Make Money in Commodities in 1960.
The first version of the indicator used a special modification of the moving average, which was calculated as a typical price (arithmetic mean between the high, low and closing price). The lines above and below the center line were drawn at a distance, with the indicated distance being a simple moving average of the trading ranges for the last 10 days.
Then, in 1960, Linda Raschke modified the indicator by suggesting that the average true range (ATR) be used to indicate the channel width. After that, trader Robert Colby suggested using an exponential moving average (EMA) instead of a simple moving average (SMA) in the Keltner Channel. Currently, traders use the indicator version as modified by Raschke and Colby.
The purpose of creating the indicator was to determine the trend change on the market and find entry points at favorable prices. To find favorable prices, the borders (the upper channel line and the lower channel line) were added.
It is assumed that if the price reaches the lower band, the market is oversold and you should look for long positions. If the price reaches the upper band, the market is assumed to be overbought and short positions should be favored. The direction and angle of the channel shows the general trend. The price around the middle line indicates the equilibrium state of the market.
How to Calculate the Keltner Channel
There are many ways to calculate Keltner Channels because traders have changed the formula and adapted the indicator to different markets.
However, there is one generally accepted approach. The middle line of the channel is an exponential moving average (EMA) with a period of 10 or 20. The average true range (ATR) is calculated over a certain period of time (10 or 20 bars) and multiplied by a multiplier, which is usually 1.5 or 2.
The resulting true range value is added to the middle line value to obtain the upper channel boundary and subtracted from the middle line value to obtain the Keltner channel lower boundary.
Thus, there are three lines on the chart, which together represent the channel. By using the Keltner Channel strategies along with other technical analysis tools, a trader can get a good trading toolset.
Keltner Channel Formula
The Keltner Channel formula is quite simple. The indicator is calculated in 3 stages. First, the middle line of the channel is calculated, then the upper and lower lines are calculated.
1. Keltner Channel Middle Line = EMA
The middle line, as mentioned above, is an exponential moving average. The EMA* is calculated in 3 stages:
I. Calculation of the SMA (simple moving average). The SMA for any given number of time periods is simply the sum of the closing prices for a given number of periods divided by that number.
Example. The 20-day SMA is the sum of the closing prices for the last 20 days divided by 20.
SMA = (data(1) + data(2) + …+ data(20)) / 20, where
data(n) is the closing price for period n.
II. The multiplier for the weighting of EMA is calculated according to the formula:
k = 2 / (N+1), where
k is the weighting multiplier,
N is the number of days in the exponential moving average.
III. EMA is calculated using the following formula:
EMAn = EMA(n-1) + k × (data(n) – EMA(n-1)), where
EMAn is the exponential moving average for n-periods,
n is the number of periods,
k is the weighting multiplier,
data(n) is the closing price for period n.
*EMA in the Keltner Channel is typically used with a period of n = 20.
2. Keltner Channel Upper Band = EMA + 2 × ATR
At this stage, you need to calculate the upper boundary of the channel. The exponential moving average is added to the average true range (usually the average daily movement, ATR) multiplied by 2.
3. Keltner Channel Lower Band = EMA – 2 × ATR
At the last stage, the lower boundary of the channel is calculated. The exponential moving average is subtracted by the average true range (usually the average daily movement, ATR) multiplied by 2.
ATR is a moving average of the true range values. This parameter is calculated using the following formula:
ATR = Moving Average (TRj, n), where
TRj is the largest of the modules of three values:
|High – Low|, |High – Closej-1|, |Low – Closej-1|.
So the true range (TR) is the largest of the following values:
the difference between the current high and low;
the difference between the previous closing price and the current high;
the difference between the previous closing price and the current low.
Keltner Channel Indicator Calculation: Step-by-Step Guide
Let’s calculate the GBP/USD Keltner Channels together. Let’s take the value 20 as the indicator period, and 2 as the multiplier for calculating the upper and lower borders of the channel. Let’s calculate the Keltner Channel for the GBP/USD pair as of February 17, 2023.
1. First, we calculate the EMA for February 17 for 20 periods:
February 17 EMA = 1.21378
Then we calculate ATR for 20 days:
ATR for 20 days = 1,196 pips
2. Now we multiply the resulting ATR value by 2 and get 2,392. This value must be added to the EMA value of 1.21363:
1.21363 + 0.02392 = 1.23755
This is the upper boundary of the Keltner channel.
3. At the next stage, we calculate the lower boundary of the channel. To do this, subtract 2,392 pips from the EMA 1.21363 and get:
1.21363 – 0.02392 = 1.18971
This is the lower boundary of the Keltner channel.
We check the distance to the upper and lower borders of the channel in the chart, with the Keltner Channels indicator already plotted, to make sure the calculations are correct:
Provided a small error margin in manual calculations, the calculation is correct.
Keltner Channel Settings
The Keltner Channel is available on most trading platforms by default, but not on all of them. For example, it is not among the basic indicators of the MetaTrader platform (MT4, MT5), but it is in the list of indicators in the LiteFinance personal account.
Let’s take the Keltner Channels (KC) indicator as an example and look at its settings. They are divided into two sections: Parameters and Style. In the Parameters section, you can configure the following parameters:
1. LENGTH — indicator period. The default is 20, some traders use 10.
This parameter affects the rate of change of the channel compared to the rate of price change. The lower the period, the closer to the current price the channel will be built, which means it will reflect rather short-term trends on the market. The higher the period of the indicator, the slower it moves after the price and the better it reflects medium-term trends.
Remember that the middle line of the channel is an exponential moving average. The lower the period of the moving average, the faster it is, and vice versa.
2. MULTIPLIER. It is recommended to use parameter values in the range from 1 to 2. The default is 1.
The smaller the multiplier, the smaller the channel width. The larger the multiplier, the wider the Keltner Channel becomes.
3. SOURCE – the source of data for calculations. The default value is Close Price. I recommend leaving this value unchanged.
This parameter determines which data will be used to calculate the indicator. If Close Price is selected, the indicator will be calculated based on the closing prices of the candles. The following options are also available to the trader:
Open Price — calculation based on opening prices;
Low Price — calculation based on the lowest price of the bar;
High Price — calculation based on the highest price of the bar;
(High + Low) / 2 – the high and low of the bar are added, then divided by 2, and the Channel is calculated based on the resulting value;
(High + Low + Close) / 3 – Typical Price: calculation based on the typical price of the bar;
(High + Low + Close + Open) / 4 – calculation based on the average price of the bar;
Volume — calculation based on volumes traded within the range of the current bar.
4. The “Exponential MA” checkbox on a separate line presents the choice between an exponential moving average (EMA) or a simple moving average (SMA) as the middle line of the channel. I recommend enabling this parameter so that the canonical EMA is used as the middle line.
5. RANGE CALCULATION METHOD. By default, Average True Range is selected. Average True Range (ATR) is a moving average of true range values.
You can also select: True Range or Range. We have discussed the True Range above. If you select Range, the difference between the high and low of the bar will be used.
6.ATR PERIOD OF KELTNER CHANNELS – the period for which ATR will be calculated. The default value is 10. Some traders use the same value that is set in the LENGTH parameter.
This parameter affects the width of the channel. The smaller the value, the more the top and bottom lines of the Keltner Channel will curve. The larger the value, the smoother the top and bottom borders will be. It is recommended to leave the parameter value equal to 10 or 20.
7. In the Style section, you can customize the appearance of the indicator, and set up the color of the lines. You can also choose the color for filling the channel space in the chart.
8. The PRICE PRECISION (DECIMAL PLACES) parameter specifies how many decimal places to display in the chart. It is recommended to select the Default setting.
How to Use the Keltner Channel in trading
The Keltner Channel, like most similar channel indicators, is used to determine the global trend for the instrument and search for entry points both inside the channel and outside it.
The indicator lines are dynamic support and resistance levels that depend on the price movement direction. They provide promising low-risk entry points.
Price exit outside the channel indicates a possible return. However, in this case, the strength of the trend should be taken into account. If the trend is strong, the return may not occur, or it may occur later at other price levels. In any case, the indicator is designed in such a way that breakouts of the upper or lower line don’t happen very often. And if one happens, it requires close attention, since a very good entry point may appear here.
Strong breakout movements outside the channel usually indicate the emergence of a strong trend, which is likely to continue in the near term.
The price movement inside the channel and no inclination indicate a flat. In this case, the trader can focus on the upper and lower lines to find an entry point, and can exit the position both on the middle and on the far line of the Keltner channel.
In the hands of an experienced trader, Keltner Channels are a promising trading tool that allows you to determine the trend and find trades with a favorable reward/risk ratio.
Keltner Channel Signals
The Keltner Channel strategy gives the following signals:
indicates the direction of the general trend;
shows when there is a flat on the market;
indicates when the trend is likely to continue;
shows when a correction can start;
tells the trader when a return to the channel may occur;
offers entry points from channel lines.
Let’s consider each signal in more detail.
1. Trend direction
If the channel slope vector is downward, then the overall trend is down. There is a high probability of the price setting a new low that’s lower than the previous one. The fall in prices is likely to continue.
If the channel slope vector is up, then the overall trend is up. In this case, it is beneficial to consider buy positions, since the price is likely to rise and set a new high above the previous one.
2. The market is flat
If the channel lines do not have a pronounced slope vector and are oriented horizontally, this means that the market is trading in a range (a flat). In this case, it is profitable to work from the boundaries of the range: sell from the top, buy from the bottom; and close positions on the middle line, or on the opposite border of the channel.
In the above example, the time interval within which there was no pronounced trend is indicated by a green rectangle. Within this rectangle, blue indicates potential sell entry points near the channel’s upper boundary, and red indicates potential buy entry points near the channel’s lower boundary. Note that the slope vector was almost non-existent.
3. The trend is likely to continue
The high probability of the trend continuing is indicated by a strong price movement, which leads to a breakout of the upper or lower border of the channel.
4. A correction is probable
The probability of the development of a correction – a movement against the main trend – is indicated by the inability of buyers or sellers to break through the upper or lower border of the channel for a long period of time. In the example below, such an area is highlighted with a pink dotted rectangle.
5. Return to channel
Extreme price deviation leading to a deep exit from the channel usually indicates a further return to the channel in the future. Such movements should be exploited with caution. Confirm the entry point with horizontal support or resistance.
6. Entry points from channel lines
The example below shows various entry points from the upper, middle, and lower lines of the Keltner Channel. Depending on the situation, each of these lines can be used to find a promising trade.
Trend Pullback Trading Strategy
First you need to set up the indicator correctly. For example, for the USD/CHF pair used in the example above, the indicator settings are as follows: period – 20, multiplier – 2, ATR – 20.
The general point of the strategy is to buy during an uptrend when the price returns to the middle line and sell during a downtrend when the price returns to the middle line.
Stop loss should be placed approximately in the middle between the middle and lower bands for buy trades, and between the middle and upper bands for sell trades. The target price is near the upper line for long positions and near the lower line for short positions.
If you find that the price often triggers the stop loss order and then continues to move in the right direction, you can move the stop loss closer to the far indicator line. This will give you more wiggle room and will likely reduce the number of losing trades.
Trend-pullback strategy is a trend-following strategy that provides trades with a Reward/Risk ratio = 2, since the stop loss size is about half the take profit size. For a trend strategy, this ratio is comfortable, since in one trade you will earn 2 times more than you lose.
No need to try to take advantage of all the movements on the market and trade all the pullbacks to the middle line of the channel. Sometimes there is no trend. The channel vector direction can help you here. If the channel lines do not have a clearly defined slope, then there is no trend and the price is likely to expand the trading range.
If the price is trading between the upper and lower borders of the channel, this strategy will also not be effective. Check the indicator settings regularly for compliance with the current market. Make sure that the market follows the rules of this trading strategy. If you see that in the current market the movement does not fit into the range between the middle and far channel lines, do not use it.
Let’s go back to the example above. The uptrend is indicated here with a red arrow, and the downtrend – with a blue one.
Trade 1 could have triggered your stop loss. In this case, it was possible to re-enter after the price returned to the middle line. Trades 2 and 3 would have made profit according to the strategy.
Trades 4, 5 and 6 gave the trader the opportunity to capitalize on the downtrend. Trade number 7 did not reach the bottom line of the channel, but repeated the level of the previous low in the chart. There it could be closed or moved to breakeven. After trade 7, the trend reversed and went up again.
Breakout Trading Strategy
A breakout trading strategy based on the Keltner Channel indicator allows you to take advantage of the movements on the market that the previous strategy can miss.
Breakout strategy should be used the moment a major player becomes active. This is when the most volatile movements occur on the market, which are favorable for this strategy.
The idea is to open a buy position as soon as the price breaks the upper channel line and open a sell position as soon as the price breaks the lower channel line.
The stop loss order should be placed in the middle between the upper and middle lines for buy trades. For sell trades, the stop loss is placed approximately in the middle between the middle and bottom lines.
The take profit level is calculated by multiplying the distance to the stop loss level by 2. Thus, your potential profit will always be 2 times your potential stop loss, which gives a good risk to reward ratio for all trades in the strategy.
The example above shows 4 potential trades for the strategy. Each of them is numbered. Trade 1 brought profit. Trade 2 should have not been opened, as the angle of the Keltner Channel indicates the absence of any trend. Trade 3 brought a loss. Trade 4 was closed by take profit.
As a result, the trader opened 3 trades and earned from two of them. Considering that the profit in each trade was twice the stop loss size, this is a good profit.
This strategy is best applied to assets that tend to have sharp trend movements. If you notice that the asset is quite calm and rarely makes big moves, don’t use this strategy for it.
Trying to use a breakout strategy on an asset that doesn’t have a big price movement will result in a lot of losing trades. The price is unlikely to continue moving after the breakout of the Keltner Channel and will most likely reverse.
There must be a pronounced trend in the market. If the channel lines indicate that the asset is currently trading sideways, do not use this strategy. This is the reason the potential trade number 2 in the example above was not opened: the channel lines were almost horizontal before the breakout.
Keltner Channels vs. Bollinger Bands
These two indicators are very similar. The only difference is that the Keltner Channels use the ATR parameter to calculate the upper and lower lines, while the Bollinger Bands use the standard deviation parameter.
The interpretation of signals from these indicators is similar. However, due to the fact that the calculation of indicators is still different, they can give different signals.
The Keltner channel is still closer to trend indicators. Therefore, it is beneficial to use it when the market is showing higher highs and higher lows in an uptrend and lower highs and lower lows in a downtrend.
The presence of a trend and volatility in the market will provide the trader with enough signals for day trading. You can also use the indicator in a flat, but in this case you will have to ignore the middle line and work only from the upper and lower lines of the channel.
Limitations of Using the Keltner Channels
The effectiveness of Keltner Channels depends on proper settings. To begin with, a trader must decide how and for what purpose they will use the indicator.
The Keltner Channels can be configured to work with a trend, as well as in a flat. The values of period, multiplier and ATR settings will be very different in these cases.
The strategies described above work with the indicator settings that have proven their effectiveness. If you change the parameters, the strategies may not work because the channel ranges are either too narrow or too wide.
Despite the fact that the Keltner Channels indicator is a standalone trading system, I recommend using additional technical analysis tools for profitable trading. You can use Price Action patterns, horizontal support and resistance levels, and other indicators. It is also important to take into account the market context, fundamental factors, and economic news.
In some situations, a trader may get the impression that the market does not respect the channel lines. The market will break through these lines as if they do not exist. This can be caused by an incorrectly selected instrument, changed indicator settings, or a situation where the fundamental background is too strong and the market does not pay attention to technical indicators.
It should be remembered that the indicator is only a tool for understanding the situation on the market, and the entire responsibility for trading lies with the trader. Check the signals coming from the indicator for consistency with your trading plan and strategy. Don’t try to take advantage of all the movements on the market, but rather try to follow the trend. In this case, the indicator will be a good help providing you with profitable trades.
Keltner Channels. Conclusions
Keltner Channels is a technical indicator that can be classified as a trend indicator. This means it can be used to determine the main movement in the market and trade following the trend. Also, using this indicator, you can find situations when the market is accelerating and is likely to continue its impulse movement in the future.
When the price goes far beyond the Keltner channel under the influence of the crowd, one can consider trades for a return to the range. An important condition for making such a trade will be a strong daily or weekly level, from which the position will be opened. Additionally, such a trade can be confirmed by a Price Action pattern.
To trade during flat periods, the upper and lower lines of the channel should be considered as resistance and support levels. A trader can consider opening from these levels with a target on the opposite Channel line. The middle band in this case will be used to partially take profit in the position, or will not be used at all.
A trader needs to choose the optimal indicator parameters for each instrument and the current state of the market, however, one should not deviate too much from the default settings.
To maximize profits, you can use other technical analysis tools such as Price Action, classic candlestick patterns, technical analysis patterns, support and resistance levels, and trend analysis indicators.
The Keltner Channels indicator will be useful for beginners, as it does not require complicated fine-tuning, and the signals generated by the indicator are simple and easy to understand. On the other hand, when fine-tuned, this indicator will come in handy for professionals who want more trading opportunities or are looking for an alternative view of the market.
Keltner Channels Trading FAQs
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.