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Trading Stragegies Using Keltner Trades
Author: Linda Raschke
Chester Keltner was a commodity trader and analyst for over thirty years. He was one of the first to pioneer systems works using trend following rules. One of the systems he presented was called the "ten day moving average rule". A ten day moving average of the daily trading range was added and subtracted to a simple 10-period moving average, essentially forming "bands". These bands served a buy and sell stops by which to enter a position. His original system was traded on a stop and reverse basis which was mildly profitable to the degree any trend following system would be. By varying the bands based on the most recent average daily price range, the channels will naturally be at 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 Bollinger bands. 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. The majority of commercially available charting packages contain Keltner channels which allow you to vary the parameters. They are also very easy to program. I put Keltner Channels set at 2.5 times the 20-day average daily range centered around the 20-period EMA. This is set 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 filter to signal runaway market conditions, much as a rising ADS would do. You must have an imperative set of guidelines for when not to step in front of a trend. Runaway market conditions also require that you use a different type of trading technique as you will not get the pullbacks that you are accustomed to in countertrend swing trading. 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 an ADX, which has a longer lag. On the other hand, they will not capture the slow, creeping trend market that ADX will indicate.
Rule for defining trending markets
If the bar has a close outside of the Keltner Channels, 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 countertrend manner. Stay with trend and trail 2-bar channel stop. It is important to do your analysis of market conditions for the next day after the markets are closed. Keltner Channel measurements are on of the volatility conditions that would be noted to set up the next day's trade in a different way (or designate where to trail a stop should one be so lucky as to already be participating in the market.) Any aberration in price movement signifies the potential for some type of "outlyer" event. It is a professional trader's job to assess this and recognize the increase in risk associated with a deviation from the norm. On the equity options trading floor, a trader learned very quickly that an increase in implied volatility in the options outside of the normal volatility trading range indicates a much greater likelihood of a takeover or collapse. Many successful mechanical systems rely on a large standard deviation move to signal an entry into the market. These systems are very robust and can consistently make money over the long run. However, the corresponding volatility and vicious draw-downs (which cannot be eliminated from the systems) make them prohibitive for the average trader to follow.
The ADX is a wonderful indicator as both a trading filter and a component in mechanical systems. It sets up some very reliable trades based on pattern recognition. The purpose of the section is to discuss it in the context of intermediate term analysis. Later on it will be used to set specific trading strategies. Setting the default at 14 periods, I employ the following rules as a filter:
* If the ADX is greater than 30 and rising, do not fade the trend. Wait for a reversal from a climax pattern or a failure test before trading in the opposite direction. This condition, ADX>30 and rising, occurs about 15% of the time on average.
* If the ADX is less than 16 and falling, the daily trading range is not usually wide enough to trade and the noise level is too high. A low volatility condition exists which may warrant switching into a "breakout mode". When momentum is strong enough to register a trend reading in the ADX (above a 30 level threshold), it calls for a retest in the price action of the newly made highs or lows. The first retracement tends to find support or resistance at the 20-period EMA. Either this retest will fail or a continuation leg will begin.
There are a few mechanical ways of isolating the rare minor retracements which occur in trending markets. The best technique is what I call the "Baby Grail". This is a derivative and slightly more frequent setup of the "Holly Grail" demonstrated in the Street Smarts manual. The Holy Grail is when the price first finds support (or resistance) at the 20-period EMA after the ADX has risen above 30. This first retracement tends to be followed by a retest of the recent newly formed swing high or swing low. Baby Grails occur when the price checks back a little, but falls short of reaching the 20-perioed EMA. In a n uptrend, this will be identified when the price pulls back below a 3 by 3 offset moving average. This pullback lasts only 1-3 days. The 3X3 line then offers a natural point for placing a resting buy stop (or sell stop) for reentry into trend . A stop is then placed at the most recent retracement low or high as the market should not trade back down to this price. Taylor's rules for trading Buy Days and Sell Short Days can also be applied to the pockets isolated by this pattern recognition technique. Look for the market to find support at the previous day's low in the case of the Buy Day. This will probably happen after the first day which traded from high to low, or the first down close. volatility breakout methods also work very well as an entry technique. The pullback usually contains a narrow range day where the market pauses before continuing back up. Placing a resting entry stop at a predetermined amount away from the previous day's close ensures that range expansion is occurring in the direction of the initial trend., The trader will automatically be on board. A second set of mechanical rules that can be used in conjunction with a Keltner Channels is to enter on the close of the first bar to close outside the Channels. The low (or high) of the this initial entry bar should be used as the initial stop. The direction of the trend are extremely high. The 3X3 offset SMA functions as an excellent trailing stop for this trade. A great majority of the time it will also setup another reentry into trend, too. Remember, a runaway market to the upside will tend to exhaust itself by having a strong morning and a weak close, "trapping" the late-comers. Never get sucked into selling morning weakness in strong up-trends. Only the close will tell you when there's no shorts left ( vice-versa for downtrends).
Street Smarts is the ability to understand the psychological part of the game. It is the ability to understand that the market is probably going to the obvious, but in the most un-obvious way. It is knowing that there will most likely be a series of false breakouts before the real one occurs, or knowing that a bull market is going to continue until the bears throw in the towel. There is a hook to every setup. Traps are constantly set to bait the over confident traders. In other words, the market is nothing more than a poker game at times. It forces you to call its bluffs. Will it bluff three times in a row, or will the third time be for real? All a trader can do is make educated guesses. This is why money management is so important. You never want to call a market's bluff without having a stop in place incase the move's for real. It is often in congestion areas that the market likes to bait the most traps. These appear in the forms of false breakouts and are often given names such as springs, shake-outs, and up-thrusts. This is where it pays to be on guard for last hour failures in the case of a move to the upside. The smart money wasn't around to support a real move. The rest of the herd will probably get out of their trapped long positions the next morning when they realize there's no follow-through. A savvy trader will position himself properly short on the close to take advantage of this. In an up-trending market, the Smart Money likes to let the market drift down in the first hour, with the hopes that they can buy more at better prices than the previous day's close. In downtrends, they'll stand back and let foolish bottom fishers bid the market up in the first hour before resuming their selling campaigns. short traders are slightly more sophisticated than long-side players. Always ask yourself how eager are the shorts to cover their position, especially going into the close!
The Crowd Has A Mental Breaking Point
The market has far more patience than the majority of traders. There is an old saying that market will do whatever it takes to drive the most amount of people crazy. This will mean, for example, that if people continue to look for an upside play in gold, the market can go sideways for years instead. If it appears that a bull market in the grains is an obvious play, the market will first have violent whipsaws so as to totally aggravate any mechanical systems or long term players who insist on a buy and hold strategy. If traders finally catch on to the fact that the market tends to rally in the last three day of the quarter, the next time it will rally a week earlier and then sell-off violently the last day to trap the late-comers. If the majority of the people think that the bull market in stocks can't possibly recover from another sharp decline and make a "V" bottom for the upteenth time,...guess what...it can! Trends can persist as long as there are traders fighting them. This means price trends or volatility trends. Our fast paced society has shortened our time frame and compressed our reality. We expect instant feedback, immediate results, and instant satisfaction. We forget that the market has its own timetable and that big moves can take years to unfold. It is one thing to study these moves on paper, and quite another to capture them in our bottom line. The majority of novice trader's time expectations will be way out of line. The market will always persist inn violent whipsaw action or straight up runaway moves much longer than your think it will, much longer than you can tolerate it. Remember, the market's mission is to find the crowd's breaking point. This is one of the ways it can win the battle of attrition.
Wait for the flush and squeeze
In congestion areas, a trader should look to trade reversal patterns at the edges of the congestion zone, for small profits only. if a congestion area is very "obvious" to the market place, one of the best "plays" is to wait for the last "flush" from the congestion and then look to go the other way. Sometimes these patterns are very analogous to an Elliott fifth wave out of a fourth wave triangle. However, I've found that many time these "flushes" only last one bar. Nothing is worse than thinking that a market is near the end of its move but getting in one bar too soon. Wait until the last long has been shaken out. Don't buy dull ledges in downtrends thinking that market has stopped going down. Be cynical, for it is in choppy congestion areas that the market can be most easily manipulated. Up-trends end when there's nobody left to buy. Make sure the market has had its last hurrah. It will usually look its best before it goes down. You want to make sure that it looks so good that nobody could even think about being short. Make sue that it looks like nothing is ever going to be offered for sale again! There is an old market saying, "Never sell a dull rising market short!" Always wait for the "blow-off"! Markets often have on last "goosing" just to make sure there are no shorts left!
About the author:
Linda Bradford Raschke began her trading career in 1981 as floor trader making markets in equity options on the floor of the Pacific Coast Stock Exchange. In 1984 she became a member of the Philadelphia Exchange, where she expanded into trading futures. In 1987 Linda left the trading floor to concentrate on trading futures only. However, she continued her 16-year study of technical analysis and price behavior, developing proprietary trading tools, methodologies, and systems based on her floor-trading experience. Linda continues to teach traders how to trade and is actively involved in presenting trading workshops and online seminar for companies such as the MarketClub Trading Service. To learn more about the INO Marketclub software, this website has a good in-depth review of the service: Marketclub Service.