Similar to Bollinger Bands, Keltner channels form bands around a moving average to illustrate the volatility present in the market at a given time. Unlike Bollinger Bands, which use standard deviation to measure volatility, Keltner channels use an indicator called the Average True Range, or ATR. ATR was developed by J. Welles Wilder, who also developed the Parabolic SAR, the Relative Strength Index (RSI) and the Average Directional Index (ADX).
The ATR is based on another indicator created by Wilder, the True Range, or TR. This essentially measures the greatest distance between:
- the previous close and the current low (absolute value of previous close minus current low)
- the previous close and the current high (absolute value of the current high minus the previous close)
- the current high and the current low (absolute value of the current high minus the current low)
Whichever of these is greater, that is the true range for that time period. Being a distance, the true range is an absolute value and cannot have a negative value. Therefore, the true range measures volatility only and records no direction whatsoever. The average true range (ATR) is a 14-day smoothed moving average of this true range.
This is what the ATR looked like for EUR/GBP during April and the early part of May 2018 on the 4-hour charts.
The Keltner channels themselves are composed of a 20-day exponential moving average (EMA), an upper channel line of the same 20-day EMA shifted up by a value of the 10-day ATR times a multiplier. This multiplier scales the channel out further. In Forex, a multiplier of 2 is typically used, though there are times when a multiplier of 1 is appropriate.
In this chart, the area shaded in red is bounded by KC(20,1), the area shaded in blue is the extent of KC(20,2), while the area shaded in green shows the area bounded by KC(20,3). KC(20,3) means to use a 20-day EMA and a multiplier of 3.
How to Use Keltner Channels
As Trend Termination Signal
Free candles above or below the Keltner channels are commonly used as a trend termination signal. Free candles are candles whose low is above the upper band of the Keltner channel or candles whose high is below the lower band of the Keltner channel. Notice how the free candles highlighted below on AUD/JPY seem to foretell that the current trend will stop soon.
Again, free candles do not indicate that the trend will reverse, just that the trend will not continue. The price could go sideways for a while or it very well could undergo a trend reversal.
Others use Keltner channels as a way of identifying the strong moves that identify the start of trends. In strong uptrends, the price rides the upper bound of the Keltner channel. In strong downtrends, the price rides the lower bound of the Keltner channel. Notice below how price rode the lower bound of the Keltner channel down during this downtrend in AUD/USD on the 4-hour chart from 2018. One strategy is to identify this trend and then wait for a pullback to the middle line. Once the price moves downward from that line, buy and place a stop-loss halfway between the upper bound and middle line.
Identifying Upper and Lower Extent of Trading Ranges
In trading ranges, the Keltner channels can be used to identify the overbought and oversold levels. See below how the price of USD/CAD on the 2-hour chart seem to bounce off the upper and lower bounds of the Keltner channel using KC(20, 1). In ranging markets, where the ADX (Average Directional Index) is less than 30, it is appropriate to use a multiplier of 1 with the Keltner Channel. There appear to be about 40-60 pips of possible profit with each downtrend and uptrend in this range. You could wait until the price crosses either the upper or lower band and then enter the position once the price enters back within the bounds. Then once the price reaches the other extreme, move the stop loss to that bound so that the position is closed once it crosses back into the channel. You could also reverse the position and go the other direction at that point.
Why Use Keltner Channels Instead of Bollinger Bands?
Bollinger Bands appear very similar to Keltner channels and both indicate volatility in the market. Many of the same trading strategies are used for each. So why use Keltner channels instead?
Keltner Channels are based on the average true range, which is in turn based on a smoothed moving average of the true range. Due to the smoothing that happens with the average true range, Keltner Channels are smoother than Bollinger Bands. Bollinger Bands are based on the standard deviation, which introduces more volatility.
While Keltner Channels and Bollinger Bands serve similar purposes, they provide a slightly different way of explaining the price action in a market. Keltner channels do fit the market a little closer. Keltner Channels are just another way to find a statistical advantage in the market, when maybe Bollinger Bands do not quite fit. Keltner channels are available in most broker-provided Forex platforms. They are not included in MetaTrader4, but they can be downloaded.