- : September 24, 2020
- : Prashant Shah
Chester W. Keltner (1909-1998) was a Chicago grain trader. He worked with successful traders who back-tested trading systems. He talked about Ten-Day Moving average trading rule in his book How to Make Money in Commodities in 1960.
He did not claim that he invented the strategy so origin of this idea is uncertain. But people started referring it as Keltner channel after the book. There are two versions of Keltner channel. First is explained by Keltner in his book, and the other one is a modified version.
I will use 10-day period to explain the indicator. It can be calculated using any other period.
First format: There are three parts of Keltner channel explained by Keltner in his book:
ATP: ATP is Average Typical price. Keltner calculated bands on Typical price instead of closing or High, Low price.
Typical price = (High + Low + Close) / 3
Average of Typical price of last 10 days is Average Typical Price (ATP). ATP is a Middle band of the indicator.
Range of any candle is a difference between the High and Low price.
We can calculate average of last 10 bar’s range.
- 10-bar ATP of Nifty is 11000
- 10-bar Average range of Nifty is 100 points
Upper band = 11100 (ATP + Average range)
Lower band = 10900 (ATP – Average range)
Range is volatility. So, we can call them volatility bands. The indicator was modified by Linda Raschke in 1980s.
Below are modifications:
1 – EMA instead of ATP
2 – ATR instead of Range
3 – ATR Multiplier range
EMA on closing price is calculated instead of Typical price. EMA gives more weightage to recent data. 10-day EMA is a middle band.
Average True Range (ATR) is a popular indicator devised by J. Welles Wilder.
True Range = Maximum of (Current High – Current Low, Current Low – Prev Close, Current High – Prev Close).
Calculate Average True range of last 10 bars. Multiply this value by ATR Multiplier to calculate the bands. Default ATR multiplier value is 2.
- 10-bar EMA of Nifty is 11000
- 10-bar ATR of Nifty is 100 points
Upper band = 11200 (EMA + (ATR * Multiplier))
Lower band = 10800 (EMA + (ATR * Multiplier))
Clear about both the versions of Keltner channel? Most of the software plot this new version of indicator as Keltner channel indicator. We plot both the versions in TradePoint.
ATR is a popular choice for stoploss placement. This indicator is calculated from the moving average and remember moving average smoothens trend. So, basically these Keltner channels are ATR bands. Bollinger band uses standard deviation, Keltner channel uses ATR. Both are volatility-based channel indicators.
You need to define three parameters in the indicator. Length of moving average, ATR period and ATR multiplier. 10 or 20 period moving average and 10-day ATR period is recommended It can be experimented as per the preference.
Now, let us dissect and understand more about the indicator.
Moving average is a basic indicator we plot on the chart to identify the trend. ATR is indicator that measures the volatility.
- Falling ATR = Narrow range
Remember, Keltner channels are calculated using the middle band. We calculate middle band first in this case. So, rising channel mean EMA is rising (uptrend), and falling channel means EMA is falling (downtrend). ATR Multiplier decides the range or width of bands
- When price is above middle band & both bands are rising = Price is above MA & it is rising
- When price is below middle band & both bands are falling = Price is below MA & it is falling
- Difference between bands is high = Volatility is high
In simple words, implement bullish strategies when price is above upper band and bands are expanding. And vice versa.
Price closing above upper band is bullish because it shows volatility range breakout. This Band breakout strategy is useful but narrow bands when volatility is low and moving average is hovering around price can result in whipsaws. Behaviour of band changes as per the ATR multiplier used. I recommend strategy A when ATR multiplier is 1 and strategy B when ATR multiplier is 2 or more.
Strategy A: When ATR Multiplier is 1.
- Difference between bands is low = Narrow range
- Buy when price closes above upper band and follow the stop-loss of lower band.
- Sell when price closes below lower band and follow the stop-loss of upper band.
Strategy B: When ATR multiplier is 2 or more.
- Buy when price closes above upper band and follow the stop-loss of middle band.
Strategy A is a SAR method. These are just to give idea about possibilities and explain the logic of indicator. Some other indicator can be used in combination with Keltner bands.
It is applicable on all types of charts and it can be traded with confirmation of price patterns as well – I personally like this type of setup. Continuation and reversal price patterns near band extremes are useful
- Sell when price closes below lower band and follow the stop-loss of middle band.
If you are following ATR, then you should explore this indicator. Experiment with parameters. Someone did that and indicator is modified. Logic of indicator remains same, volatility bands from average price. Formula was adapted to new possibilities.