Sideways Indicators Keltner Channels and Bollinger Band

Introduction to the Squeeze Play
The Squeeze Play is a volatility setup. It actually begins with an unusual lack of volatility for the market that you are trading. In other words, a market is trading with much less volatility than is usually the case judging by the market's historical data. Key point: The Squeeze Play relies on the premise that stocks and indexes fluctuate between periods of high volatility and low volatility. When periods of low volatility occur, a market should eventually revert back to its normal level of volatility.

The well-known Bollinger Bands and... ...the much less well know Keltner Channels. With both the Bollinger Bands and Keltner Channels, I use the standard default settings that are used on vast majority of trading platforms that I've seen: Bollinger Bands: Length 20, Standard Deviation, 2 Keltner Channels: Length 20. There are two versions of the Keltner Channels that are commonly used. I use the version in which the bands are derived from "Average True Range." When I have looked at how Keltner Channels are configured in different charting programs, I've noticed that there can be some minor variations. You should not only be sure that you're using the formulation that uses Average True Range, but also that the center line is the 20-period Exponential moving average.

Bollinger Bands were made famous as a trading tool by John Bollinger in the early 1980s. A Bollinger band tells you the amount of volatility there is a given market relative to the recent past. When a market is very volatile relative to the recent past, the Bollinger band will expand. When a market is going through a period of low volatility relative to the recent past, the Bollinger band will contract.
A Bollinger Band consists of three lines that are plotted for each day’s close over the course of time. A simple moving average. The simple moving average plus two standard deviations derived from closing prices. The simple moving average minus two standard deviations derived from closing prices. Different parameters in the Bollinger Band can be adjusted such as the period of the simple moving average and the number of standard deviations used. Use parameters that are usually the standard default setting. Bollinger Bands: Length 20, Standard Deviation, 2 Now, the statistical term that you don’t commonly hear in normal conversation is “standard deviation.” Understanding this term is the key to understand how a Bollinger Band detects and displays fluctuations in the degree of volatility. In plain English, standard deviation is determined by how far the current closing price deviates from the mean closing price. The formula for computing standard deviation is rather complex and I’m running the risk of oversimplifying (and offending math Phds) but the general concept is that the farther the closing price is from the average closing price the more volatile a market is deemed to be. And vice versa. That is what determines the degree of contraction or expansion of a Bollinger Band.

Here’s What’s Missing In Bollinger Bands 
Before I get on with the discussion, let me state that I’m sure there are many traders who find the Bollinger Bands to be a valuable trading tool by itself. I think that’s fine and I wish them well. I only know that my own personal requirements as a trader from a risk/reward standpoint dictate that I need more information than what I can get from Bollinger Bands alone. As students of Bollinger Bands know, when the bands get "narrow", a breakout is about to occur. But how narrow is narrow? Chart created on Market Warrior, the flagship product of Chart 1 Note: The blue lines are Bollinger Bands. At point 1 the Red arrows are indicating a Bollinger Band Squeeze. At point 2 the Red arrows are indicating another Bollinger Band Squeeze. What’s hard about this situation is you do not know how to qualify this squeeze. What we need to do is to quantify how narrow is narrow so that you can determine when a potential trade is triggered. The way we do this is to add the Keltner Channel to the chart.

What are Keltner Channels?
Keltner Channels, which were originally created by Chester Keltner in 1960s and later modified by Linda Raschke, look similar to Bollinger Bands. They consist of a center line with an upper band and a lower band. The big difference between these two indicators is the following: Bollinger Bands: The distance of the outer bands from the center line is based on the movement of the closing price. The more the closing price moves from day-to-day, the more the outer bands expand away from the center line. Keltner Channel: The distance of the outer bands from the center line is based on the range from the high to low on a daily basis. The more the trading range varies, the more the outer bands expand away from the center line. As with Bollinger Bands, the formula for Keltner Channels is rather involved. We could get into it, but I'd rather just convey the general concept. The idea behind Keltner Channels is that the distance between the center lines and outer bands represent the mathematical norm. As such, you would normally expect to see all of the current price action contained within the bands of the Keltner Channel. The traditional use of the Keltner Channel is to look for a trading opportunity when the price action breaks outside of the Keltner Channel. When that happens, it means that an unusual level of momentum is coming into the market and a strong directional move may be underway. But here is the most useful observation from the perspective of the Squeeze Play. Go back and look at the Bollinger Band definition. Remember, the bands are a function of how much the current closing price differs from the average closing price. That's simplifying it a tad, but that is the general idea. Now, the Keltner Channel is based on the range between the high and the low. Let me ask you a question. Which do you think will tend to exhibit more change when the market goes from an abnormally non-volatile state back to normal volatility state? a. The difference between the current close and the average closing price or b. The range between the high and the low Here's my answer: While both values will tend to change, the answer is "a." Closing values will tend to exhibit more change than the trading range. As a result of this the outer bands of the Bollinger Bands will tend to expand and contract faster than the outer bands of the Keltner Channels. Now See chart 2 below Bollinger + Keltner.

Sideways Indicators Keltner Channels and Bollinger Band

Now you can see how this relationship allows us get a clear indication of potential trades stemming from volatility expansions. Bollinger Band=Blue Keltner Channel=Red In chart 2 now that we have the Keltner Channel overlaid on top of what you saw in Chart 1, we can qualify the Squeeze. You only take a squeeze play that meets the following criteria: You only consider taking a squeeze play when both the upper and lower Bollinger Bands go inside the Keltner Channel. Points 1 and 2 show examples of the Bollinger Bands (blue lines) going inside the Keltner Channel (Red lines). At those points, you know the squeeze has started. When the Bollinger Bands (BOTH blue lines) start to come out of the Keltner Channel (red lines) the squeeze has been released and a move is about to take place. Bollinger Bands and Keltner Channels tell you when a market is transitioning from low volatility to high volatilty. Using these two indicators together is a valuable technique in itself and I would imagine that some of you would be able to make use of it. In additional of this 2 super indicators, add momentum + Volumn and apply the knowledge of candlestick will further enchance your power in Squeeze Play.


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