December 28, 2016 01:00 PM
While the grand number of available technical indicators can threaten paralysis by analysis if you tried to use them all, Keltner Channels offer a unique view of trends and are worth a look.

Keltner Channels are volatility-based envelopes set above and below an exponential moving average (EMA). This indicator is similar to Bollinger Bands; however the Keltner Channels use the Average True Range (ATR) to set channel distance instead of a standard deviation measure as with Bollinger Bands.

Chester Keltner, in his 1960 book “How to Make Money in Commodities,” plotted channels as a multiple of daily range (high - low) around a moving average of typical price. Linda Bradford Raschke popularized a simplified version, using exponential smoothing and ATR, which is now more widely used.

The channels are typically set two ATR values above and below the 20-day EMA. The EMA dictates direction and the ATR sets channel width. Keltner Channels are a trend following indicator used to identify reversals with channel breakouts and channel direction. The Keltner Channel is used to signal possible price breakouts, show trend and give overbought and oversold readings (see “Channeling the S&P,” below).

Calculation

There are three steps to calculating Keltner Channels:

1. Select the length for the exponential moving average.
2. Choose the time periods for the ATR.
3. Choose the multiplier for the Average True Range.

By default technical analysts use 20-period EMAs with envelopes using ATR and a multiplier of 1:

Basis = 20-Period EMA

Upper Envelope = 20-Period EMA
+ (2 X ATR)

Lower Envelope = 20-Period EMA
− (2 X ATR)

Traders should remember the following two points while defining your Keltner Channel trading strategy: The longer the length of the exponential moving average, the greater the lag on the indicator; and the higher the multiplier, the greater the width of the Keltner Channel.

Trading signals can be created two ways using the Keltner Channel: Trend confirmation and overbought/oversold signals.

Trend confirmation

During a clear trend, breakthrough above or below the envelopes can be a sign of underlying strength of the trend. During a Bullish Trend, a breakthrough above the upper envelope can be seen as a sign of strength and the uptrend is likely to continue. During a bearish trend, a breakthrough below the lower envelope can be seen as a sign of weakness or bear trend strength and the downtrend is likely to continue.

Keltner said that a close above the upper band (or below the lower band) is evidence of a strong move and should be traded as a breakout. The following rules can be used by traders to trade Keltner signals in a trending market.

• Longs initiated when price breaks above the upper band with a stop loss below the moving average (middle line) and exit if price closes below the moving average (middle line).
• Shorts initiated when price turns below the lower band with a stop loss above the moving average and exit if price crosses above the moving average (middle line).

“Time to buy,” (below) shows a buy signal for Abbott Laboratories (ABT) as its stock closed above the upper band of the Keltner Channel on July 6 at \$40.58. Traders can carry on the long until they do not see a reversal pattern or do not close below the moving average, which happened on Aug. 19 at \$44.20, a move of almost 10% was captured.

“Time to sell,” (below) shows how shares of Alaska Air Group Inc. (ALK) closed below the lower band of Keltner Channel on June 14 at \$61.20, initiating a sell signal. Traders can carry on the short until they do not see a reversal pattern, which happened on June 27, where it formed a doji pattern, suggesting a reversal. Traders can book out on a reversal confirmation, which happened the next day. A close above the moving average at \$59 happened on July 11 where traders need to cut down all positions.

Overbought/Oversold signals

When a market is choppy or trading sideways, Keltner Channels can be useful for identifying overbought and oversold conditions. These conditions can typically lead to price corrections where price moves back toward the moving average. The rules for trading Keltner overbought/oversold signals are:

Go long when prices turn up at or below the lower band. Close your position if price turns down near the upper band or crosses to below the moving average.

Go short when price turns down at or above the upper band. Close your position if price turns up near the lower band or crosses to above the moving average.

“Range trading,” (below) shows that whenever price is unable to close above the upper channel overlay, it tends to fall back toward the middle line. This allows traders the ability to earn consistent small short-term profits, as with our example in Alcoa (AA).