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Wednesday, January 5, 2011

Keltner Channels

Keltner Channels are volatility-based envelopes set above and below an exponential moving average. This indicator is similar to Bollinger Bands, which use the standard deviation to set the bands. Instead of using the standard deviation, Keltner Channels use the Average True Range (ATR) to set channel distance. The channels are typically set two Average True Range values above and below the 20-day EMA. The exponential moving average dictates direction and the Average True Range sets channel width. Keltner Channels are a trend following indicator used to identify reversals with channel breakouts and channel direction. Channels can also be used to identify overbought and oversold levels
Chester Keltner introduced the “Ten-Day Moving Average Trading Rule”, which is credited as the original version of Keltner Channels. This original version started with a 10-day SMA of the typical price {(H+L+C)/3)} as the centerline. The 10-day SMA of the High-Low range was added and subtracted to set the upper and lower channel lines. Linda Bradford Raschke introduced the newer version of Keltner Channels in the 1980s. Like Bollinger Bands, this new version used a volatility based indicator, Average True Range (ATR), to set channel width. StockCharts.com uses this newer version of Keltner Channels.
There are three steps to calculating Keltner Channels. First, select the length for the exponential moving average. Second, choose the time periods for the Average True Range (ATR). Third, choose the multiplier for the Average True Range.
Middle Line: 20-day exponential moving average
Upper Channel Line: 20-day EMA + (2 x ATR(10))
Lower Channel Line: 20-day EMA – (2 x ATR(10))

The example above is based on the default settings for SharpCharts. Because moving averages lag price, a longer moving average will have more lag and a shorter moving average will have less lag. ATR is the basic volatility setting. Short timeframes, such as 10, produce a more volatile ATR that fluctuates as 10-period volatility ebbs and flows. Longer timeframes, such a 100, smooth these fluctuations to produce a more constant ATR reading. The multiplier has the most affect on the channel width. Simply changing from 2 to 1 will cut channel width in half. Increasing from 2 to 3 will increase channel width by 50%.