Keltner Channel Indicator

Let's take a look at the Keltner channel indicator along with some real chart examples to provide context as to how it can be traded, along with details of the drawbacks of using this indicator, so that these drawbacks can be considered before taking trades.

The Keltner Channel is a technical analysis tool to identify potential trading opportunities based on volatility and trend direction. Named after Chester W. Keltner, who introduced the concept in his 1960 book "How to Make Money in Commodities," the Keltner Channel is similar to Bollinger Bands but differs in its calculation method. It is constructed using the Average True Range (ATR) to set the channel distance from an exponential moving average (EMA).

The Keltner Channel indicator consists of three lines:

1. Middle Line (EMA): An Exponential Moving Average, typically set to 20 periods.

2. Upper Channel Line: EMA plus a multiple of the ATR (commonly 2 times the ATR).

3. Lower Channel Line: EMA minus the same multiple of the ATR.

Trading with the Keltner Channel

Traders can use the Keltner Channel indicator to identify breakout opportunities, and trend directions. The breakout strategy consists of buying when the price breaks above the upper channel line and selling when the price breaks below the lower channel line. A possible exit strategy would be to use a trailing stop or exit when the price crosses below the middle line if a long trade and above the middle line if a short position.

On this Gold chart, there is a significant breakout candle outside the top line of the Keltner channel. This was a clear breakout and would have been a good entry point. Most of the post breakout candles managed to maintain price levels at or around the upper channel line corroborating the bullish move. The safest exit point for the trade would have been where it is marked the 'exit candle'. Alternatively, only part of the position could have been exited and part of the position could have been maintained, should there be a continuation, which was the case in this instance.

It all looks so easy right? However, applying this strategy in isolation is unlikely to be a long term profitable strategy. In the case above there were a number of factors that were in play that made the probability of the breakout being successful higher:

• There had been a long period of consolidation in a relatively tight range. This would indicate that once the price breaks out of that zone it will likely continue: and

• If you look at the price action post breakout, the price when returning to the upper keltner line was rejected, a great confirmation.

In this next example, on the daily Bitcoin chart, there is a breakout candle outside the lower Keltner channel line, a strong bear elephant bar. The way to trade this type of scenario is to enter a short position at close of the candle and place a stop loss at the high of the candle, as pictured.

It is important to appreciate that such simple strategies without further information exposes the trader to riskier trades, context is everything before entering a trade. In the example above, the Bitcoin price was consolidating after it had entered a bear market, having been making lower highs and lower lows. This channel that price was ranging in, as demonstrated by the rectangle was a consolidation phase. There was always a higher probability this was going to break down and continue the trade based on the market structure. Zooming out and understanding where an asset is in market structure terms is critical to increasing the directional probability of your trading.

The daily chart on the stock of Lemonade is an example of why moves outside the channel without proper research and understanding of where the asset is in its cycle can hurt your win / loss ratio and your capital. In the example above there was the potential for significant financial pain.

The chart shows that the price had been volatile for a significant period of time with lots of up and down price movements. The price, as shown, shot out of the Keltner upper channel line and closed. This would have been a painful trade if entered.

The next day, the stock gaps down from a high of $22 per share to $16 per share, a 27% fall in price. If a trader had entered this trade the day before and did not have a stop loss or a guaranteed stop loss, a significant financial loss would have been incurred. There was enough information on the chart suggesting that a trade shouldn't be taken, even though the Keltner channel had been broken. If you look to the left of where the breakout candle closed, the price was actually filling a gap down where a significant move down had occurred from previously. This information alone was enough information to not go long.

Drawbacks of the Keltner Channel

Although some of these have been covered with the example immediately above, despite the Keltner channel being a useful indicator, there are several limitations:

• False Signals: Like any indicator, the Keltner Channel can produce false signals, especially in choppy or sideways markets. Breakouts may not always lead to sustained trends.
  

• Lagging Indicator: The Keltner Channel is based on moving averages and the ATR, both of which are lagging indicators. This means it might be slow to react to sudden market changes.
  

• Adjustment Needed: The standard settings may not work for all assets or market conditions. Traders often need to adjust the EMA period and ATR multiplier to suit specific assets or trading styles.
  

• Complexity in Volatile Markets: In highly volatile markets, the Keltner Channel may widen significantly, making it challenging to determine precise entry and exit points.

Conclusion

The Keltner Channel is a versatile tool in a trader’s arsenal, useful for identifying trends, breakouts, and overbought or oversold conditions. By combining it with other indicators and adjusting settings as needed, traders can enhance its effectiveness. However, it is crucial to be aware of its limitations and to use it as part of a broader trading strategy to manage risk and increase the likelihood of successful trades.

The key point to remember is that this indicator, like other indicators are lagging and a trader must pay attention to the price action as it is happening along with support and resistance levels.

Trade Clearly!