Option Investor
Trader's Corner

Revisiting Nested Keltner Channels

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A quirk in our website makes it difficult to access archived articles. That is, it's difficult unless one enjoys paging through old newsletters one by one, looking for something that might address the desired topic. When I began including intraday Keltner charts in my Thursday Wraps, readers asked for information. The only way to provide that information in any reasonable way is to revisit the topic in new articles. I will try to include new information that might benefit long-time subscribers, too, such as information on how I use Keltner channels to set up my credit spread trades. I literally would not trade without Keltner channels, so I hope readers old and new will glean something useful from studying them, too.

I won't be able to cover everything in a single article. However, I will go through the information in as few articles as possible.

I employ nested Keltner channels to determine where support or resistance might lie, make judgments about the strength of that support or resistance, and ask myself if/then questions that help me determine when my assumptions about the market might be confirmed or violated. I also use them to determine when markets are in a runaway mode, times when countertrend or so-called fading-the-move trades should not be attempted. Perhaps the manner in which Keltner channels helps me most resides in setting upside or downside targets if support or resistance is broken. This proved particularly helpful back when the Russell 2000 was hitting new highs earlier this year, and there wasn't any previous overhead supply to provide resistance. Where was resistance? Keltner channels helped me determine potential resistance levels.

The original purpose of Keltner channels was not included in that list, at least not as their presumed developer intended. Charles Keltner is credited with formulating these channels, considered a kind of moving-average envelope, for the purpose of identifying breakout moves that might be traded.

Keltner did not term these channels "Keltner channels." That's a name that traders using them have bestowed upon them. He called the system he developed that employed them the "Ten-Day Moving Average Trading Rule." He also did not claim that he was this indicator's developer. No one seems to know whether he was their developer or simply the person who first gave them enough press that they were noticed and used by others.

Although many traders abhor playing breakout moves, some old-time technical analysts believe that trading these breakout moves proves more profitable over the long run than trading the old buy-at-support/sell-at-resistance plays. However, traders must have enough patience, confidence in the ultimate long-term outcome and money in their trading account before they can capture that supposed long-term profitability. Trading breakout plays, hoping for long-term profitably, guarantees enduring long periods of whipsawed trades, one of the drawbacks of this type of trading pattern. Most of us just don't have all three of those characteristics. A series of nine whipsawed trades in a row would be more than most of us or our trading accounts could comfortably endure.

That's okay. We can use Keltner channels in many ways other than their intended use. I, too, want to identify breakout moves, for example, but my reasoning is different than Charles Keltner's. In my daytrading days, for example, I wanted to know when a move might be faded or when such a tactics was more dangerous than usual. Now that I trade differently, I want to know when an index is in a breakout mode and might blast through all the support or resistance levels between the current price and the sold strikes on my credit spreads.

I don't want to trade breakout moves. I want to know when to get out of their way.

Annotated 10-Minute Chart of the SML:

As is obvious, this wouldn't have been a particularly good setup for a long play on the breakout. It would likely have been one of those times when a trader going long would have been whipsawed out of a trade, and it points out one of the dangers of trading breakout moves. This time, the breakout instead served as a warning that an upside move off the 3/7 low had just about topped out.

However, if I had been considering a bearish scalp on the SML or RUT or one of their component stocks, I also would have been warned. In order for such a breakout to occur, the momentum in small caps must have been strong. That momentum renders oscillators such as the RSI almost useless. In this case, a bearish trader who entered a play early Thursday morning, as the upper channel line was tested, might not have even been shaken out of the play before the SML did indeed roll over and hit the central channel support again. However, what might have been intended as a scalp would have long turned into a daytrade as the trader waited out several hours until price began rolling down about 2:00. A more favorable entry, at least more favorable when frayed nerves are considered, could have been attempted as prices were sustained below the channel boundary again.

The channel pictured on that graph was based on a 120-period exponential moving average, not one of the moving averages that Charles Keltner used, a least not to my knowledge. I first discovered the settings I use in an article by Jerry Wawrzeniak ("The Case for Keltner Channels").

Keltner constructed these namesake channels around a central moving average, spacing the envelope around that moving average by a multiple of the average true range. The multiple employed on that channel pictured above is 7.2, and this is the widest of the three channels I typically employ.

It's possible to tinker around with the moving average, the multiple and the time frame to find a channel that contains most movements of the underlying trading vehicle. Until a new breakout occurs, that Keltner channel can then be coupled with an indicator such as RSI to trade the channel's parameters, employing a buy-low/sell-high approach.

If you're trading credit spreads and looking at a three-day or weekly chart instead of an intraday one, you could use Keltner channels to help determine where your credit spreads should be placed. Since these Keltner lines are dynamic and will move in the direction of price, I never place my sold strikes right at identified channel boundaries, but instead want to get outside them, allowing both for that dynamic quality and for any changes that might occur in the configuration of the channels during the time my spread might be working.

Remember that because of my family situation, which requires frequent and unscheduled times away from the markets due to a disabled family member, my articles are prepared in advance of their publication date and do not include current prices.

Annotated 10-Minute Chart of the SML:

I set up this channel, based on a 45-ema, by using a multiple of 3. This is the second widest of the channels I employ. On many indices, intraday moves during non-trending periods tend to be contained within this channel on the 7-minute, 10-minute or 15-minute charts. The time interval chosen tends to vary according to the index being watched. For a period during late February and early March, the SML and the Russell 2000 tended to stay within the boundaries of this channel on the 10-minute chart on the quiet days between breakouts.

The channel can be watched on daily or other intervals, too.

Annotated 3-Day Chart of the SML:

You might be thinking that's no great trick. The 45-ema channel on the 10-minute chart (not the 3-day one immediately above) has flattened, and you might as well draw straight trendlines across the chart to determine where support or resistance might lie as go to the bother of constructing Keltner channels. It's true that on a trend-less day, the channels tend to go horizontal after a period of time. However, that flattening of the channel does not render it useless. The flattening provides information that the current movement is without trend.

An upturning or downturning channel also often contains price movement, but such changes in direction of the channels can alert traders to watch out for breakout moves and not to assume that channel resistance or support will hold.

Annotated 3-Day Chart of SML:

These charts have introduced ideas about using Keltner channels to pinpoint breakouts and determine support and resistance, but that second topic is far from exhausted. That topic will be covered further in the Trader's Corner article next weekend, and discussions about setting targets will be added.

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