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Keltner Channels in a Trending Market

When attending a trading conference that included several new Option Investor subscribers, I realized that many had missed my previous articles on nested Keltner channels. I sometimes mention these channels in my Trader's Corner articles or Wednesday night Wraps, and new subscribers likely find such information confusing. Some attending the conference mentioned that they had never studied or used Keltner channels. That's not unusual: few in the trading world have. Articles discussing them prove few and far between.

Although new subscribers might need a primer on these channels, long-time readers have either long since set up Keltner channels on their own charts or decided that this charting tool doesn't fit their trading styles. I don't want to repeat the information from those old articles and bore long-time readers, so I thought this article should tackle a new slant that has been appropriate to the recent trading environment: using Keltner channels in a trending market and using them to determine whether the trend is still in place.

New subscribers might benefit from a brief review of Keltner channels, named for Charles Keltner. Keltner formulated these channels as a type of moving-average envelope. That's important when considering whether a market is a trending one, because moving averages can identify trending moves.

Since my articles are often written ahead of time, the charts may not be the most current ones. These aren't.

Annotated 30-Minute Chart of the Russell 2000 with 45-ema:

As long as the RUT kept producing 30-minute closes above that 45-ema and kept bouncing from it, traders were forewarned that the rally mode continued.

While the rally mode persisted, that 45-ema provided a benchmark for traders but not an upside target. That's where the Keltner channels come into play. One of the three nested channels I watch is built around a 45-ema. Charles Keltner formulated these channels with the envelopes spaced around a moving average by a multiple of the average true range. In the case of the 45-ema channel, the multiplier that I use is 3.

Annotated 30-Minute Chart of the RUT with One Keltner Channel:

Once a trend has been established, Keltner channel boundaries help set targets--upside ones in the course of a rally and downside ones when a decline is underway.

The tests of the 45-ema late 11/20 and early 11/21 resulted in a bounce to the outside Keltner channel boundary, where resistance was found. Twice, that upper channel location helped set potential upside targets, targets that were eventually met.

To review, Keltner channels have provided two tools for a trending market: determining whether a trend exists or persists and setting targets. They can provide other tools. Even in a trending market, it's useful to determine when support or resistance might be firming. This helps traders determine whether a trend's support or resistance might continue to hold or might break, or decide whether an upside or downside target is feasible. When two or more Keltner channels are nested on the same chart, that firming proves easier to discover.

Annotated Thirty-Minute Chart of the RUT, Two Keltner Channels:

The same principle works on longer-term charts and with three nested channels rather than two.

Annotated Three-Day Chart of the RUT:

Notice that the firming resistance did not stop the RUT from pushing higher, even though that resistance did basically hold on three-day closes.

However, something else had been holding, too: the support offered by the 9-ema, the thin red line on that chart. Although it had been breached by a few points on a few closes, so that the support wasn't perfect, the RUT had been mostly closing above that average or bouncing quickly back above it if there were minor breaches. That had been going on for months as May began. The RUT was trending over the intermediate term and not just on an intraday chart. Watching the RUT's action with respect to this support had shown that the trend was still intact.

That's one reason that, despite the firming resistance, the RUT was able to test it several times. The trend wouldn't be over until the RUT began consistently closing three-day periods below that average, then bouncing back from it when it rose to test it from the underside.

That began happening in May. A new trend had begun, a downtrend identified by prices closing beneath the red 9-ema on that three-day chart. Downside targets could be set at lower channel boundaries. The process was repeating, and, eventually, support could be seen thickening as channel lines lined up in June and July.

Was that what was happening when prices broke through the support of the 45-ema on Friday, November 24, in the pattern seen in the first charts at the beginning of this article?

Certainly, a downside target could have been set at the bottom channel line, a downside target that was simultaneously set and almost met during the same 30-minute period.

Annotated 30-Minute Chart of the Russell 2000's Downside Target:

These charts have illustrated the ways that Keltner charts can be used to identify a trend, set upside or downside targets as prices continue to bounce up from or back from a key moving average, and then determine when the trend might be weakening due to firming or softening of support or resistance.

Putting together all this information, what do Keltner channels show about the RUT as of noon Friday, December 08, 2006?

Annotated Daily Chart of the RUT:

The rally trend continues, but there's enough evidence here to urge protection of bullish profits if not to confirm that the trend is about to end. Keltner resistance lines are beginning to converge above the RUT's current position, but notice that those Keltner lines still slant upward, the blue and black rather strongly? That suggests that resistance is beginning to firm, but the lines haven't flattened enough to provide convincing evidence that the RUT will be repelled without at least reaching for the 809 level. It could be, as it's showing some Keltner-style bearish divergence. This is seen with each successive test of the upper black channel line since October. The first test broke prices strongly above that channel; the second, less strongly. That's Keltner-style bearish divergence. We have to factor this evidence together with what we know about the RUT's propensity to overrun targets. It looks as if the 801.55-809.40 zone is setting up as a zone for a potential short-term top, but the RUT can and does overrun such targets.

The conclusion? There's no conclusion yet except that the trend has not yet been broken, but that there is reason for bulls to be more cautious than they have need to have been for months about protecting profits while perhaps still allowing for the possibility of a continued move higher. Ratcheting stops higher, especially if there's an upside breakout out of the top channel, and letting the RUT's prices decide when the play is exited, is one tactic for a security with a chart like this.

Those who want to search the archives for more background information on Keltner channels can find my series on these channels in Trader's Corner articles on March 19, 2005, April 30, 2005, May 7, 2005, and May 21, 2005.
 

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