Identifying Overbought and Oversold Markets using The Keltner Channel

The Keltner Channel was developed by Chester Keltner back in the early 1960s. He is a well-known commodity trader, especially grains.

It is a volatility-based indicator that makes use of the "envelope theory." Moving average bands (or channels), like the Keltner Channel, fall into the general category of envelopes. These envelopes consist of three lines: a middle line and two outer lines. Envelope theory states that the market price will generally fall between the boundaries of the envelope (or channel). If prices move outside the envelope, it is a trading signal or trading opportunity. Some have used the Keltner Channel as a trading system.

The Keltner Channel can be used to help identify overbought and oversold conditions in a market. When a market's price is close to the upper band, the market is considered overbought. Conversely, when a market's price is close to the bottom band, the market is considered oversold. However, this study can be used to help determine the strength of a price trend. Some traders use a market price move and price close that is above the upper band of the Keltner channel as a buy signal, and use a push below and price close below the lower band as a sell signal.

An advantage of Keltner Channel compared to other channel indicators is that market lag is not as pronounced because Keltner Channels are extremely sensitive to fluctuations in volatility.

The Keltner channel is not as well known as other channel methods, such as Bollinger Bands or the Commodity Channel Index (CCI).

To calculate the center-line moving average of the Keltner Channel, you take a moving average-­usually 10 periods. You then multiply that moving average price by a number, such as 1.5, to plot the upper and lower bands.

Well-known and respected trader and educator Linda Bradford Raschke has relied upon Keltner channels in her trading methods. When I was a reporter for FWN several years ago, I did a feature story on her.

She says Keltner Channels can serve as buy and sell stops by which to enter or exit a position. Keltner's original system was traded on a stop-and-reverse basis, which was mildly profitable, said Raschke.

By varying the bands on the most recent average daily price range, the channels will naturally be a greater distance from the market when the price swings are wide than when they are narrow. However, they will stay at a much more constant width than other envelope methods.

"You can see how you would have participated in the majority of a trend if you used Keltner's rules. Unfortunately, you would have experienced many whipsaws, too. This is because the system's intentions are to keep you in the market all the time," Raschke said.

"I put Keltner channels set at 2.5 times the 20-day moving average daily range, centered around the 20-period moving average. This is wide enough so that it contains 95% of the price action. In flat-trading markets, as indicated by flat moving averages, it serves as a realistic objective to exit positions. However, I find its greatest value is in functioning as a filter to signal runaway market conditions, much as a rising ADX would do." (The ADX, or directional movement index, helps determine market trend.)

"Keltner channels will identify runaway markets caused by a large standard deviation move or momentum thrust. Thus, they can alert one much earlier to unusual volatility conditions than the ADX, which has a longer lag. On the other hand, (Keltner channels) will not capture the slow, creeping-trend market that an ADX will indicate," said Raschke.

Her rule for defining trending markets: "If the bar (on the bar chart) has a close outside the Keltner channel, or trades 50% of its range outside the band, with a close in the upper half of its trading range, the market should not be traded in a counter-trend manner."

Jim Wyckoff
TradingEducation.com