The Keltner Channel and Bollinger Bands

Published: 30th December 2009
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Channels and bands of various origins have been used to study market price movement by day traders from many disciplines. They have an uncanny ability to point out the obvious, which is not always as obvious as it might seem, that is to say bands and channels can show the volatility and direction of the market and be read at a glance. They are easily read and interpreted.

Let's start with the methodology of Keltner Channel. The Keltner Channel is similar to most channels or "envelopes" in that it uses three lines. The center line is a moving average set to a specific time period of your choice, and the default on most charting programs is set to ten, though day traders have adjusted this number to their specific needs in a variety of ways. The outer bands are then calculated by multiplying the center moving average by another number of the day traders choosing, usually 1.5x or 2.0x. This simple math should point out one major difference between the Keltner Channel and Bollinger bands; the line tend to stay equidistant most of the time. This makes sense since the multiplication factor produces a linear relationship to the moving average on both outside lines.

The best known day trader who utilizes the Keltner Channels and has published some articles on the topic is Linda Bradford Raschke. Without quoting her verbatim, if you have the multiples set up for a particular day and most, say 90% of the price action stays within the channel, you would be able to spot overbought and oversold signals to work around. But this explanation also points out what is, for me, the real weakness in using Keltner Channels.

How do you know, on a daily basis, which multiples of the moving average to use and, for that matter, what time frame is appropriate for the moving average itself. I suppose with years of experience you might develop the ability to judge the market and set the appropriate variables, but it sounds like a fairly tall order for a novice trader. Raschke has done work integrating the Average True Range indicator into the moving average with some success, which seems a more accurate methodology to my way of thinking. The point is simple, though; the Keltner Channel methodology would take some very specific mentoring to be an effective trading tool for your indicator set. At best, it serves as a nice filtering device for other primary trading indicators.

The Bollinger Bands, on the other hand, also use a preset simple moving average (SMA) as the center of it's three line array. I generally see the Bollinger Band SMA set around 20, but any number will cause a set a bands to be formed and Bollinger, in his book, thought variations on the twenty period SMA in different markets could produce sacrosanct results. Instead of using a preset multiple of the SMA the Bollinger Bands set the outer lines at two standard deviations from the center line. The level of standard deviation can be altered, but the generally accepted norm seems to be about two standard deviations. So we are dealing with a non-linear outer line formation now, since the standard deviation changes in size depending upon the position of the center line. When the market is consolidating, Bollinger Bands tend to draw very close together, showing a very low level volatility. Conversely, when the volatility is increasing, the bands will swing wildly away from each other and the width between the outer bands becomes greater.

Contrasting this with the more equidistant demeanor of the Keltner Channel will immediately show the casual day trader the difference in these two indicators. One is linear, one is non linear, and the reality is that they appear very different on a chart. Oddly enough, though, I consider the Bollinger Band to be a secondary indicator, though there are trading systems that use them as a primary indicator. The general rule of thought on both the Keltner Channel and Bollinger Bands is fairly simple: a close outside the channel is indicative of overbought and oversold conditions and hence, there is a potential counter-trend trade in the offing.

My experience has been that the Bollinger Bands are more accurate at predicting countertrend moves. Again, I would use them as a filter device and see if, in fact, my primary indicators show the same information. I think you could say the same for the Keltner Channel, which I have used less.

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