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How to trade using the Keltner channel indicator

The Keltner channel is a volatility indicator used by traders to assess whether an asset’s trend might continue or change direction. Here, we explain how to calculate it and how to use it in your trading.

Source: Bloomberg

What is the Keltner channel?

The Keltner channel – named after its creator Chester W. Keltner – is a channel indicator which seeks to identify areas of volatility in an asset’s price movements. Similar to other technical indicators which track volatility – such as Bollinger bands – the Keltner channel uses three separate lines to assess an asset’s volatility based on price action and support or resistance levels.

For reference, support and resistance refer to separate levels which appear to restrict an asset’s price movements. Support is the level at which an asset’s price might stop falling; resistance is the level at which an asset’s price might stop rising.

The first of the three lines for the Keltner channel is an exponential moving average (EMA), and the second and third lines – placed above and below the EMA – display an average true range (ATR) of the asset’s previous price action. If the asset’s price closes above the upper band – resistance – or below the lower band – support – of the channel, then it could signify that there will be either a change in the prevailing trend, or a trend acceleration.

How to calculate KC with the Keltner channel formula

Many trading platforms – including IG’s online trading platform – will calculate Keltner channels automatically for you. However, to calculate the Keltner channel for yourself, you’ll first need to calculate the EMA for an asset in a given time frame.

The EMA is simply a moving average which gives greater weighting to an asset’s most recent price movements. Most traders will use a 20-day EMA for Keltner channel calculations. The following steps will help you to calculate the EMA:

1. Calculate the SMA
2. Calculate the multiplier for weighting the EMA
3. Calculate the current EMA

Firstly, to calculate the SMA you just add up the asset’s closing prices for a given time frame and then divide the sum by the individual number of periods. For example, a 14-day SMA is simply the sum of all the closing prices for the a 14-day time frame, divided by the number of individual periods of 14.

Next, you’ll need to calculate the multipliers. The multipliers for weighting the EMA are constants, meaning that they are fixed to their individual time frames. For example, a 14-day EMA has a weighting of 13.33%. This is achieved by the weighting formula, which is:

For a 14-day EMA, you would divide 2 by (14 + 1) and multiply the outcome by 100 to achieve a percentage of 13.33%. For a ten-day EMA, you would divide 2 by (10+1) and multiply the result by 100, giving you 18.18%.

Finally, once you have worked out the SMA and obtained your weighting multiplier you can calculate the current EMA. To calculate the current EMA with the weighting multiplier in mind, you would do the following:

Taking a close price of 1.4560, a previous EMA of 1.4558 and a weighting multiplier for a ten-day EMA as the constant 18.18%, we would get the following calculation:

You would repeat this process over the time frame that you want your EMA to represent, with many traders choosing a 20-day EMA. If you chose a 20-day EMA, once you have calculated the 20-day EMA for your Keltner channel, you can use it to calculate the upper and lower bands. The upper band is usually a 20-day EMA plus double the average true range; the lower band is usually a 20-day EMA minus double the average true range.

To calculate the average true range, you would first need to calculate the true range, which is the largest number of the following:

• The current high minus the previous close
• The current low minus the previous close
• The current high minus the current low

For a specific time frame the first true range is simply the current high minus the current low, and the first average true range is an average of all the previous true ranges in the time frame – 20 days for example. After that, to achieve each subsequent average true range you would multiply the previous 14-day ATR by 13, add the most recent day’s ATR and then divide the result by 14.

What does the KC tell traders?

The Keltner channel tells traders when a trend is likely to reverse or accelerate. As the graph below shows, the trend reversal is labelled where the price of the asset breaks through and closes above the upper band of the Keltner channel.

Traders can use areas at which the price of an asset has closed above or below the two bands of the Keltner channel as possible areas of support or resistance. These areas can help to determine whether the price of an asset will continue on its current path or reverse against the prevailing trend.

You should use the Keltner channel alongside other technical indicators such as the relative strength index (RSI), other moving averages or Bollinger bands. This is to ensure that a trend reversal or continuation is confirmed before you open or close any positions based on findings from the Keltner channel indicator.

How to use the Keltner channel when trading

You can use the Keltner channel in your trading to show areas at which you might want to open buy or sell positions. Generally, traders will open a buy position as the price of an asset starts to rise toward the lower band of the channel after falling through it.

On the other hand, traders might want to open a sell position after the asset’s price has broken through the upper band and is starting to fall back towards the channel. It is worth remembering, that just because the price has fallen or risen outside of the lower or higher band of the Keltner channel, it doesn’t always signify that this will continue.

Using Keltner channels on MT4

MetaTrader 4 (MT4) is a popular platform for automated and algorithmic trading. MT4 is primarily used by forex traders, and because FX is a very volatile market, the Keltner channel is one of the most used indicators on MT4.

Just like a range of other platforms, MT4 has the functionality to automatically apply Keltner channels to your charts while using the platform. Aside from the Keltner channel, MT4 comes with a host of indicators and add-ons, some of which you get for free when you download MT4 from IG.

Keltner channel vs Bollinger bands

While the Keltner channel has similarities to Bollinger bands, there are also some differences such as how the two indicators are calculated. The Keltner channel uses an average true range set either side of an exponential moving average, while Bollinger bands use a standard deviation set either side of a simple moving average.

Because Keltner channels are based on the average true range, they are smoother in appearance compared to other indicators, which means that they can filter out smaller price movements to help traders identify the prevailing trend.

The exponential moving average which the Keltner channel is based on also tends to react quicker to market movements as opposed to other forms of moving average. However, the Keltner channel does not have the clear ‘squeezes’ and ‘bounces’ of Bollinger bands, which show areas of high and low volatility very clearly.

What to consider before trading with Keltner channels

There are several things to bear in mind before trading with Keltner channels. For example, Keltner channels cannot give definitive indications of future price levels; instead working from historical price action to show potential trend reversals, accelerations or continuations.

Because of this, the Keltner channel is best used alongside other technical indicators to greater confirm the indicator’s findings.

Keltner channels summed up

• The Keltner channel is a volatility indicator, named after Chester W. Keltner
• It is used to show possible areas on a price chart where an asset’s prevailing trend might continue, reverse or accelerate
• Keltner channels use an exponential moving average, surrounded on either side by an average true range
• The indicator can be configured to different time frames, but many traders will use it over and in conjunction with a 20-day EMA
• While the Keltner channel can show areas of increased volatility, it cannot give indications of price levels and is best used in partnership with other technical indicators

This information has been prepared by IG, a trading name of IG Australia Pty Ltd. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients.

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