Option Investor
Trader's Corner

If/Then Statements with Keltner Channels

Printer friendly version

Even the best trade setups occasionally turn sour. A recent article described how nested Keltner channels can be used to determine breakouts and set targets, but they can also confirm when Keltner-based trades turn sour. They allow the construction of if/then statements that set specific goals for preserving or invalidating a breakout signal.

An example occurred Thursday and Friday, April 21 and 22. A breakout signal was invalidated. The OEX had been building a broadening formation at the bottom of its drop off the April 12 high, alternating rallies with steep descents. Thursday had been a rally day. The OEX had risen to test its 200-sma, the 38.2% retracement of its fall from the April 12 high and nested Keltner resistance. Climbing above and maintaining the 200-sma into the close would have been a coup for bulls, and so it might have been assumed that a drive into that average would occur near the close. It did, creating a new Keltner channel breakout signal in the process.

Note: Background and settings for the nested Keltner channels discussed in this article can be found in the Sunday, March 20 Traders Corner article.

Annotated 15-Minute Chart of the OEX for Thursday, April 21:

Experienced traders might have found the breakout suspicious. Reasons included the already stated notion that the late-day push had been intended to close the OEX back above its violated 200-sma. In addition, the drive stopped short of the 50% retracement of the plummet off the April 12 high and had taken on the look of a bearish rising wedge.

A suspicious trader might have wanted to know Thursday evening what would be needed to invalidate that breakout signal the next morning. The breakout above that black channel had suggested the OEX would move to the outer boundary of the next wider channel, so a 15-minute close beneath the black channel line would be needed to invalidate the signal. Thursday night, a trader would have been able to construct the following if/then statement: If the OEX closes a 15-minute period candle below the Keltner line currently at 553.29, then it will have invalidated the breakout signal. The upside target would be erased. At the open, the Keltner line might move somewhat: hence, the "currently at" part of the statement.

Take another look at that chart from Thursday, April 21 and note the thin red line. That's the central basis line of the smallest channel, the blue one. When that blue channel turns up, the OEX is moving higher. When it turns down, the OEX is moving lower. When it flattens, the movement is losing momentum. If OEX closes had been above the red basis line, a close below it would tend to flatten the blue channel. If closes had been below the basis line, a close back above it would tend to flatten the blue channel. A trader looking at that chart Thursday evening would know that a 15-minute close beneath that red line would tend to flatten the blue channel. It would be a signal that the upward movement might be losing momentum.

Friday morning, that upside target was erased by a 15-minute close beneath the black channel line, and the small blue channel started to flatten after a close beneath the central basis line.

Annotated 15-Minute Chart of the OEX, April 22

That first 15-minute candle corroborated the impression that Thursday's breakout was not to be trusted. Friday, April 22, the OEX eventually dropped to a low of 546.88 before bouncing. Trading had been volatile for days, with breakouts untrustworthy, but the ability to construct an if/then statement based on Keltner evidence had given traders concrete levels to watch. They knew when a breakout play was being invalidated and its target erased.

Even working trades see short-term retracements against the position. Knowing when a trade still works despite those to-be-expected retracements proves just as important as determining when trades turn sour. Keltner-based if/then statements can be used for that purpose, too.

Annotated Daily Chart of the TRAN:

On the chart above, the red central basis line of the small blue channel shows up in bold to make it more visible. Continued daily closes beneath that basis line kept the TRAN's smallest Keltner channel pointed down and the TRAN traveling lower within that channel. The if/then statement that market watchers might have constructed was as follows: As long as the TRAN produces daily closes beneath the red line, then the TRAN remains vulnerable to declines toward the lower black channel line.

Another statement could be constructed. If the TRAN began producing daily closes above the red line, then the TRAN was trying to steady and the downside thrust might be losing momentum. Bears in transportation stocks might have been alerted to a deceleration in downside momentum. This did happen, but the TRAN was to switch gears again the next day, April 22, and then resume its downward course.

A special situation exists when if/then statements do not work as well. This occurs when the Keltner channels flatten and line up, one within the other. This equilibrium state occurs when prices consolidate in a tight range over a prolonged period. The central basis lines of the various channels converge, and appear to be strong support or resistance. Traders might be tempted to construct if/then statements that sound like the following: If prices close above/below the mid-channel level, then the upside/downside target is at the next outer channel boundary.

Annotated 15-Minute Chart of the Dow, Early April

With this easily recognized exception, nested Keltner channels offer traders an easy way to gauge whether a Keltner-based trade still works or has been invalidated.

Trader's Corner Archives