Keltner channels are indicators that measure price volatility, and they are made up of three lines. The middle line is an exponential moving average (EMA), while the outer lines are derived from the average true range of price. Keltner channels appear quite similar to Bollinger bands when applied to a chart, but the two indicators are quite different. Keltner channels use the ATR to calculate the upper and lower bands, while Bollinger bands use standard deviation for the same purpose.
Chart 1: GBP/USD daily chart with Keltner channels
How to calculate Keltner channels
Keltner channels are calculated using the formula below:
- Middle line = 20-period EMA of price
- Upper band = EMA + (2 * ATR)
- Lower band = EMA – (2 * ATR)
These figures are calculated at the end of each period and plotted on the chart to create a continuous line.
It is common practice to calculate both the EMA and the ATR using the same number of periods. Some traders may choose to use a lower number of periods, such as 10, to calculate both the EMA and the ATR.
Keltner channels originally used simple moving averages (SMAs) to calculate the middle line as well as the upper and lower bands, but not many people use SMAs today because of the time lag associated with the indicator.
The EMA is much faster than the SMA because recent price values have more weight in the EMA; the SMA, meanwhile, assigns equal weight to both past and current values.
Therefore, the EMA is the default formula used to find the middle line in Keltner channels, while the outer bands are calculated using the ATR indicator thanks to its high accuracy.
How to use Keltner channels
Keltner channels can be used for several purposes. One is to identify trend direction. This is accomplished by looking at the direction in which the channels are angled, with an upward angle representing an uptrend and a downward angle indicating that price is in a downtrend.
A sideways trend is usually confirmed whenever the channels are flat. This means that they are neither angled upward or downward, which usually indicates that the price is trading in a sideways range.
You could also gauge the strength of a downtrend by the number of times price hits the lower channel, while the opposite is true of the strength of an uptrend, which can be determined from the number of times that price hits the upper channels.
What about trade entries?
There is no given formula for timing your trade entries using the Keltner channels. Unlike Bollinger bands, its signals are not that reliable. This is illustrated by the chart below.
Chart 2: GBP/USD chart with Keltner channels and potential trade entries
Red arrows: These represent ideal short trade setups where the trend was about to reverse, creating excellent shorting opportunities.
Green arrows: These indicate areas where the trend was about to reverse, creating excellent buying opportunities.
The arrows above pinpoint excellent trade entry positions for traders who wanted to profit from such opportunities, but there is no clear way of identifying the setups from the Keltner channels.
It is hard to identify these opportunities because traders typically enter long trades when price touches the upper band, and they also enter into short trades once price touches the upper bands.
Combining Keltner channels with price action principles
However, if you had been monitoring the price action on the chart, you would have gotten into the above trades simply because the reversals happened at support and resistance levels.
This demonstrates that the key to finding trade setups using Keltner channels is by combining the indicator with price action principles to catch massive trend reversal and breakout trades.
All the long and short trade setups above happened at previous support and resistance levels that are identified easily by drawing horizontal lines from past support levels to the present price.
We will cover price action trading in another article.
The bottom line
Keltner channels are an indicator that is calculated using the EMA and ATR indicators and is quite good at identifying the current trend direction. However, you have to combine the indicator with price action principles or another indicator if you want to use it to identify potential trade setups.