Part II: The Basics

TEN-DAY MOVING AVERAGE RULE

Figure 6.2 Keltner Buy and Sell Lines. The buying and selling prices can be combined to form bands, (source: How to Make Money in Commodities by Chester W. Keltner, Kansas City, Mo.: The Keltner Statistical Service, 1960.)

Table 6.1 Keltner Band Formulas

Keltner Buy Line:

10-day-moving-average typical price + 10-day moving average (high-low)

Keltner Sell Line:

10-day-moving-average typical price - 10-day moving average (high-low)

from the average of the typical price to produce a selling line. When the price fell below the selling line, you closed any long positions and sold short (reversing your position from long to short). See Table 6.1 for a summary of Keltners formulas. Keltners techniques are significant in several ways:

First, the use of the typical price was insightful. The typical price gives a better feel for the price where the majority of trading usually occurs than does the most commonly used price, the close or last. By including the opening price, the typical price also picks up some reference to the activity that occurred between sessions. This is especially useful in todays markets where the quote you get may not cover all the significant trading activity in that period. For example, a quote on an NYSE stock will usually reflect the NYSE session, and may or may not include off-exchange or

Chapter 6: History

after-hours trading. In addition, significant activity occurs overseas, which may or may not overlap the primary session covered by your quote. For simplicity and clarity in this book, we will use the close, but we urge you to consider employing the typical price in your operations.

Second, Keltners use of the daily range to determine the interval between the average and the band foreshadowed the more fully adaptive methods that were taken up later. The daily range also incorporates an aspect of volatility into the process, which we think is crucial to success.

Third, if both the buy and sell lines were projected simultaneously and continuously, rather than in Keltners checkerboard or alternating fashion, you would have what might have been the first example of a trading band (Figure 6.3) in the sense that became popular later.

In the 1960s Richard Donchian took the simple, but elegant, approach of letting the market set its own trading envelopes via his four-week rule. The concept was simplicity itself. One bought

Figure 6.3 Keltner Channel, IBM, 150 days. Keltners buy and sell lines combined to form trading bands.

Part II: The Basics

when the four-week high was exceeded and sold when the four-week low was broken. In a subsequent test of computerized trading systems, this rule was selected to be the best of many tested by Dunn & Hargitt, a well-respected commodity trading and analytics firm of the time.

The four-week rule was soon turned into envelopes by drawing lines equal to the highest high of the past four weeks and the lowest low of the past four weeks. This concept of setting the upper limit at the n-period high and the lower limit at the n-period low is often referred to today as a Donchian Channel (Figure 6.4). This concept is rumored to be at the heart of one of the more successful trading approaches in wide use today, that employed by the Turtles.3

In 1966, Investment Quality Trends (IQT), an investment newsletter edited by Geraldine Weiss, introduced a new type of envelope, the valuation envelope (Figure 6.5). Using an historical perspective, IQT presented monthly charts that included overvaluation and undervaluation lines based on dividend yield.

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Figure 6.4 Donchian Channel, IBM, 150 days. This is a very popular approach with commodity traders.