Volatility Channels are a type of indicator that plot volatility-related lines above and below the market. These lines are variously known as channels, envelopes, or bands. They widen as volatility increases, and narrow as volatility decreases. The most well-known volatility channel is the Bollinger Band, though the Keltner Channel Indicator is another effective type as well.

The channels or bands describe the outer boundaries of the normality of the price change. It also establishes where a band of likely support or resistance levels might lie. If the market breaks out beyond this boundary, we are alerted of an unusual occurrence, and can plan our trades accordingly.

There are numerous ways of using these bands to generate trade signals such as Squeeze, Bounce, Walking the Bands, M-Tops and W-Bottoms etc. We’ll be using a very effective method of detecting a change in the volatility of the market using the squeeze of Bollinger Bands and Keltner Channels.

Bollinger Bands

Bollinger Bands is a versatile tool combining moving averages and standard deviations to detect a change in volatility of the market. There are three components to the Bollinger Band indicator:

  1. Middle Line: 20-period Simple Moving Average (SMA)
  2. Upper Band: 20-SMA + (2 x Standard Deviations)
  3. Lower Band: 20-SMA – (2 x Standard Deviations)

Because standard deviation is a measure of volatility, when the markets become more volatile the bands widen while during less volatile periods, the bands contract. Many traders believe the closer the prices move to the upper band, the more overbought the market, and the closer the prices move to the lower band, the more oversold the market.

bollinger band
Upper and Lower Bollinger Band Lines

Keltner Channel

Keltner Channel is also a volatility based technical indicator composed of three separate lines. Instead of using the standard deviation, Keltner Channels use the Average True Range (ATR) to set channel distance. The following are the three components:

  1. Middle Line: 20-period Exponential Moving Average (EMA)
  2. Upper Channel Line: 20 EMA + (2 * Average True Range)
  3. Lower Channel Line: 20 EMA – (2 * Average True Range)

Keltner Channels and Bollinger Bands are quite similar. Keltner Channels use ATR to calculate the upper and lower lines. Bollinger Bands use standard deviation instead.  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 or a Keltner Channel.

keltner channel
Upper and Lower Keltner Channel Lines

The Squeeze

When the bands come close together, constricting the moving average, it is called a squeeze. A squeeze signals a period of low volatility and is considered by traders to be a potential sign of future increased volatility and possible trading opportunities. Conversely, the wider apart the bands move, the more likely the chance of a decrease in volatility in the future and the greater the possibility of exiting a trade

Approximately 90% of price action occurs between the two bands. When the bands squeeze together, it usually means that a breakout is imminent. Expanding volume on a breakout is a sign that traders are betting with their money that the price will continue to move in the breakout direction. If the candles start to break out of the top band, then the move will usually continue to rise. If the candles start to break out below the lower band, then the price will usually continue to fall. This strategy is designed to catch a move as early as possible.

bollinger band squeeze
The Squeeze

Setting Up

The concept of squeeze can be applied to both Bollinger Bands and Keltner Channel individually. Typically, the Keltner Channels tend to be tighter than Bollinger Bands. On the other hand, the Bollinger Bands tend to represent market volatility better since the expansion and contraction movements are much wider and explicit as compared to Keltner Channel. However, to improve the accuracy of our predictions, using both the indicators together will act as a confirmation of volatility reversal and breaking out of the Bollinger Band can then be used as a trade signal. We’ll be using the default look-back period of 20 for both the indicators and a multiplication factor of 2 for the upper and lower lines.

Defining the Squeeze

Prior to generating both buy and sell signals, we need to make sure that the price is consolidated and the market volatility is low. The squeeze is defined when both the upper and lower Bollinger Bands go inside the Keltner Channel i.e. Upper Bollinger Line is less than Upper Keltner Line while Lower Bollinger Line is greater than the Lower Keltner Line. This acts as a double confirmation of the squeeze and indicates a possible reversal of volatility from low to high in the near future.

Defining a Bullish Scenario

Once a squeeze has occurred, a price breakout from the upper Bollinger Band would indicate the possibility of an uptrend in the future. This is backed by the fact that once the price starts breaking out of the bands, it would mean a relaxation of the squeeze and the possibility of high market volatility and price movement in the future.

Defining a Bearish Scenario

Similarly, a price breakout from the lower Bollinger Band after a squeeze would indicate the possibility of a downtrend in the future and an increased market volatility in the same direction.

bollinger band and keltner channel trading strategy
How the price remained consolidated during the squeeze and plunged after a lower breakout

Building on Mudrex

Since the buy/sell signal is always preceded by a squeeze, we need to use the concept of “X Candles Ago” on Mudrex. This would mean that the Bollinger Bands should lie inside the Keltner Channel X candles before the price breakouts. X = 5 is the optimum number of candles which should lie between the squeeze and the breakout.

As discussed above, let us first write our entry/exit conditions so that we know what to do while building our strategy:

Buy when:

  • Upper Bollinger < Upper Keltner [5 Candles Ago]
  • Lower Bollinger > Lower Keltner [5 Candles Ago]
  • Closing Price > Upper Bollinger

Sell when:

  • Upper Bollinger < Upper Keltner [5 Candles Ago]
  • Lower Bollinger > Lower Keltner [5 Candles Ago]
  • Closing Price < Lower Bollinger

We’ll use a stop loss of 10% to prevent loses due to any false signals generated. Stop loss helps improve the percentage of trades won, by a good margin. Choosing the value of stop loss depends on how much risk you’re willing to take. A stop loss of 10% would mean your strategy will exit the trade as soon as the price drops more than 10% below the entry point in case the trade ends up in the wrong direction.

Compare block for the first squeeze condition of Upper Bollinger < Upper Keltner; 5 candles ago looks like this:

squeeze compare block

Compare block for the second squeeze condition of Lower Bollinger > Lower Keltner; 5 candles ago looks like this:

squeeze compare block

The final squeeze condition looks like this:

squeeze signal

This is common for both the buy signal and the sell signal.

Now defining the buy signal by comparing the closing price and Upper Bollinger such that the signal is triggered when Close Price > Upper Bollinger looks like this:

buy compare block

Similarly, the sell signal compare block can be set for Close Price lesser than Lower Band.

After setting up a stop loss of 10%, the overall strategy looks somewhat like this:

bollinger band and keltner channel trading strategy
Overall Strategy

And we’re done!

We can now run a quick back-test to see how our strategy performs. The recommended time-frames for this strategy are M30-D1 charts. Running one from over the past 1.5 years using a tick cycle of 12H gives us pretty convincing results:

bollinger band and keltner channel trading strategy backtest
Backtest from 2nd Nov 2018 to 2nd May 2020 using a 12H tick cycle on Bitmex BTC/USD

The Bollinger Bands and Keltner Channels notify you when a market is transitioning from a lower volatility to a higher volatility. Using these two indicators together will provide more strength, compared with using a single indicator. While every strategy has its drawbacks, volatility channels have become one of the most useful and commonly used tools in spotlighting extreme short-term prices in a security. The bottom line is that they are designed to discover opportunities that give investors a higher probability of success.

A lot of even more complex things can be done on Mudrex! Signup today!

Links

A few quick references below:

Happy Trading!