Trading in the FX market using mechanical trading strategies

The Indicator Series. The Keltner Channels, Price and Volatility

September 24th, 2010 2 Comments

Today I will continue my indicator series of posts with the study of yet another very interesting indicator which was invented by Chester W. Keltner and released on his book How To Make Money in Commodities. Within the next few paragraphs we will be discussing the mathematical basis of this indicator, the information it provides about price movements and volatility and what uses can we have for this indicator within the development of mechanical trading strategies. You will see that by analyzing what the Keltner Channels actually represent we will be able to get a clear picture about price and its relationship with volatility, we will be able to come up with sound ideas for the development of automated systems as well as ways in which this indicator can be used to aid the exit management of some trend following systems.

The Keltner Channel is a particularly confusing indicator regarding its mathematical calculation since different authors have assigned different values to the same name making different sources give us different information about how the channel lines are calculated. Originally the Keltner channels simply plotted an X period moving average surrounded by two channels formed by X period moving averages separated from the central line by the past X days average range (|High-Low|) value. The channel forming moving averages were originally calculated based on typical price but later authors have used close as well as open prices to calculate this indicator. The greatest change perhaps comes from traders like Linda Bradford Raschke who published the used of the indicator using exponential moving averages (instead of simple ones) and the use of the Average True Range indicator instead of the daily range to determine the channels width. Traditionally the indicator was calculated over 10 periods.

Despite of all the different ways in which the Keltner channels are calculated the same information is always relayed. We are shown the average of price levels with a channel formed by these same averages separated from the center one by a measure of volatility (given either by the Average True Range or the Average Range). This indicator is therefore telling us how price is behaving relative to measurements of volatility, how much it is moving in comparison to how much it has moved during the past. It is therefore an easy way to judge how fast or slowly price is moving since it gives us a relative comparison to how much  it has moved in average in the past. When price touches the extremes of the Keltner Channels it tells us that price is behaving in a more volatile way since it is reaching beyond the average volatility levels of the recent past.

The usefulness of this information seems to be limited to how you actually calculate the Keltner channels (especially around the number of periods and time frames you use). For example I have found the hourly Keltner channels not to be that useful on their own as a way to design a full trading system since the information they convey is not very trustworthy as volatility tends to show too sharply and too frequently within this low time frame. However using the daily Keltner Channels is a different story since now much longer term information exists and increases in volatility tend to signal directionality as these tend to happen when trends are getting started. Therefore it should be possible to design a Keltner Channel Daily breakout strategy aiming for a continuation of Keltner channel breakouts since these breakouts signal that price is moving towards one direction with much more strength compared to the recent past.

However there are also an interesting amount of uses for the Keltner Channel indicator, particularly in the determination of ranging markets and the creation of dynamic exits. Since this indicator gives us information about how price moves relative to volatility we can use the Keltner channel band opposite to our position as a trailing stop as the movement of our position is trailed against a certain volatility threshold which if breached would signal a possible reversal that would take our positions towards losing territory. This stop doesnt work as a traditional trailing stop in the sense that price is not continuously pulled in relationship to price but it is moved in steps each time a bar is closed and a new Keltner Channel Band High/Low is created relative to the previous stop loss level.

Another interesting use comes from the fact that price tends to remain quite calm within volatile periods and the Bollinger Bands (which show channels relative to prices standard deviation) tend to fall within the Keltner channels) as the standard deviation of price becomes small relative to volatility. This can be usefully used for the creation of some breakout strategies or more commonly for the refinement of other strategies that may be wanting to eliminate some entries that happen under these circumstances. However it is worth noting that these does not work as a universal trend/range filter and extensive analysis needs to be done in order to see if the trading system actually benefits from this assumption. As always systems need to be designed from the beginning to include this type of circumstances and modification to already existing systems with these technique in an attempt to filter bad trades will usually yield only bad results. In the end you should analyze your strategy and develop it from the beginning with these possible criteria in mind.

In the end the Keltner Channels indicator is a useful mathematical calculation that allows us to judge the movement of price relative to recent volatility. This indicator may be used for the development of a system on its own or it may be used as an additional feature of a system aiding to improve trade selection or the systems exits through the use of volatility adjusted trailing stops. If you would like to learn more about trading strategies and how you can develop your own systems based on understanding and analysis please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach automated trading in general. I hope you enjoyed this article. o)