Keltner channels are indicators that are composed of three bands, with the middle band being the 20-period exponential moving average and the outer bands being derived from applying ATR values to the middle band. The upper band is calculated by adding either 1 or 2 ATR values to the middle band; the opposite is true for the lower band, which is calculated by subtracting the same number of ATRs from the middle band.
Tips on adjusting Keltner channel settings
You can adjust the Keltner channel settings to ensure that price mostly trades within the bands to increase the accuracy of the trade signals generated by the channels. Typically, Keltner channels have a default value of 20 for the EMA (middle band) and a default multiplier of 1 ATR for the outer channels.
You will find that the 1 ATR setting usually results in price trading outside the channels on a regular basis, which typically generates multiple false signals. To ensure that price remains within the bands for a longer period, you should adjust the multiplier to 2, as demonstrated in the charts below.
Chart 1: EUR/USD chart with Keltner channels multiplier set at 1
Chart 2: EUR/USD chart with Keltner channel multiplier set at 2
Using Keltner channels to trade breakouts
Many traders use Keltner channels as part of their trading strategy because it can provide high-probability trading signals in case the price is about to break into a sustained uptrend or downtrend. The channels typically generate a broad buy signal when the price breaks above the upper band, and they generate a broad sell signal once the price breaks below the lower channel.
An innovative way to trade breakouts using Keltner channels is to focus on trading breakouts that happen within the first 30 minutes of the market open. There is usually a lot of activity in the premarket session before the markets open, and many professional traders typically execute their chosen trades once the market opens.
This means that if the price of a stock breaks below or above the outer bands, you should take the long or short trade within the 30-minute window described above. This trade typically does not have a profit target, and you only exit the trade once the price falls back inside the bands and touches the middle band.
Sometimes, the price may generate a signal that quickly reverses and closes for a small profit or loss before generating another signal in quick succession. In such cases, you should take a second trade if you had already closed your earlier trade and follow the same rules.
Chart 3: EUR/USD daily chart with Keltner channel trade entries
Using Keltner channels to trade trend pullbacks
A simple way to use Keltner channels to trade existing uptrends or downtrends is by getting good entries into an existing trend.
For example, you could enter into long trades whenever the price pulls back to the middle during an existing uptrend, and you could enter into a short trade whenever price pulls back in an existing downtrend.
Once you’ve entered into such a trade setup, you can place your stop-loss order at the middle point between the outer and middle channels. However, if your stop-loss orders keep being hit, you can move them much closer to the outer bands to give the trade enough space to either move in your direction or for the trade setup to be invalidated.
This strategy can be used for both Forex and stock trades.
Combing the pullback and breakout strategies into one
If you had used the stock breakout strategy in the morning and exited the trade for a profit when the price pulled back to the middle band, you can use the pullback strategy to find more trading opportunities.
If the price pulled back to the middle band and remained volatile despite trading within the bands, you can look for potential trade setups where the price breaks out of the channels if volatility is maintained.
You could also trade the pullback strategy if the price pulled back to the middle band and then went on to trade in a sustained downward or upward trend.
Using Keltner channels on sideways trending markets
The above chart shows a significant period where price traded in a sideways range, where you could have made money taking long trades at the top of the range and short trades at the bottom of the range.