The Keltner Channel is based on the Average True Range and is sensitive to volatility. It may be used in place of standard deviation (Bollinger) bands or percentage envelopes.
As with all envelope or band systems, the probability is that price will remain within the envelope. When price breaks though the envelope, it can be taken as a signal to either buy or sell.
When prices close above the top band, this often means a breakout in upward volatility to be followed by higher prices. When prices close below the bottom band, prices are expected to move lower.
In a rising market the middle line, or 20 period EMA, should provide support. Conversely, in a falling market it tends to provide resistance.
As with all trend following systems, the Keltner Channel works well in up trends or down trends, but doesn't work well in a sideways channel. As a trend following system it is not meant to catch tops or bottoms.
Keltner channels should be used in combination with other indicators, such as RSI or MACD, to provide confirmation of the strength of a market. An exit strategy utilizing trendlines and other indicators can be particularly important, as can be seen from the example above. Waiting for the price to close below the lower band often erodes much of the potential profits from a good move.
The calculation for Keltner Channel, based on ATR, is as follows:
Also see the overview on Bollinger Bands, Price Channel, and Average True Range.