Linear Regression Channel - how to uncover the hidden directional bias of the price flow

A trend line is just a single line that tracks a trading range moving in an up or a downtrend.

A trading range could be horizontal, defined as having a fixed-price resistance and support. Or it may move over time, either up or down.

When a trading range is on a rise, the trend line is simply a straight line plotted beneath the price. It follows the movement of the trend and shows rising support.

When a trading range is descending, the trend line is drawn above the price.

Prices usually move in trends and, while the duration of a trend may vary, it can be followed as it evolves in either direction.


The bottom line is this.


The trend line connects the initial point of the move, to the point where it stops or pauses. The trend line shows rising demand that grows as price levels rise, or falling demand synchronous with a decline in the price range.

Once that trend ends (signified by opposite move in price descending below the rising support level, or ascending above the falling resistance level) it means trend may be about to change and start moving in the opposite direction.


Think about it this way:

The strength of the short-term trend is represented by an angle of the trend line.

The steeper the angle, the more powerful is the trend.

The trend line needs to be extended in the future to validate the trend itself.

A trend line may be constructed in such a way that prices may not violate the line, or certain price spikes may be ignored, such as those that do not hold beyond a very small number of sessions.

Trend line (technical analysis)


Trend lines and what they tell us about trend

The trend line shows how evolving trading ranges behave and helps determine their ending and reversal points.

Channel lines incorporate a trend line with a second line on the opposite side of the price.

This shows how trends may contain sharp angles and yet maintain the same width.

Here’s a big idea.

A channel line represents such a movement.

It includes a trend line and a channel line, with the same proximate width of trading in between.

The technical analysis defines triangle or a wedge when one side or the other moves closer or farther away.

These contexts indicate a change in direction or momentum, and often are considered to be continuation or reversal signals.

The channel lines approach is different.


The pattern remains constant until it ends, and at that point change in direction is highly likely.

The parallel trend lines contain channels within them and set the movement apart from triangles and wedges.

It uncovers a trend that contains identical movement in both resistance and support.

As long as the channel lines are continued in its direction, it serves as a continuation pattern.

However, as soon as the dominant trend line collides with contrary price movement, it ends the continuation and that point signifies likely reversal.



Using channels to identify trends

Compared to other technical indicators, the channel lines are considered to be less complicated, and they offer multiple benefits when it comes to chart interpretation.

The current trend can be delineated in both length and direction with their help.

They indicate when trends are about to end, as well as the possibility of continuation or reversal that will follow.

When a change or continuation is validated, channel lines are revealing.

With support and resistance evolving, channel lines determine a failure to exit the established trading breadth and demonstrate continuation and final completion and change of the trend.

What’s the bottom line?

A channel is nothing more than a trading range tilted at an angle such that it shows an up or downtrend.

Trend lines contain the bounds of the channel same ways as support and resistance lines delineate the trading range.

These channels can be traded back and forth but only in the trend direction. In other words, for example, if the trend is up, only long positions are taken at the support and sold at the resistance, but no short entry is initiated opposite to the channel trend.


How can you tell that the trend is over?

The trend can be thought of as a simply a direction of equilibrium between the forces of supply and demand.

Think about it this way.

In an uptrend, the right trend line represents the growing demand and the supply is moving above the demand in a parallel fashion.

Therefore, the market has a tendency to “bounce” off this right side trend line as if supply were to be found at these moving levelsand rising at the rate similar to demand.

When the price is nearing a likely reversal point, the supply is starting to get anxious which is reflected in resistance reversal point beginning to close on the underlying trend line.

Price breaking the trend line represents the conclusive evidence of the end of the channel.

The same observations apply when price finds itself in downtrend.


A more “scientific” channel.

Linear regression is commonly used to forecast future prices based on the past.

As a mathematical technique it is used to decide whether the market is over extended.

It is sometimes referred to as the “least squares method” or “best fit”.


Linear regression calculates a line through a series of data in such a way that the sum of the squares of the distances between each data point and the line is minimized.

The line that minimizes the distance between itself and every point of the chart is referred to as linear regression line.


In other words, the least squares method is used to plot a line through prices so as to minimize the range between the prices and the ensuing trend line.

But here’s something really interesting.

A channel can be drawn by constructing parallel boundaries to contain the linear regression line.

The trend channel boundaries are spaced apart at a distance calculated using one of several possible mathematical techniques.

Most common way to space the channel lines is to use a given number of standard deviations on either side of the center line.

The linear regression line is the pure, “true” trendline, and therefore the channel built around it, called the linear regression channel, would also be the “true” channel.


There are a number of different Linear Regression studies, but they all use the same approach: a trendline is constructed which corresponds to an “equilibrium” in price.

That is, a line is plotted that represents the best fit based on past price activity.

Two additional lines are then drawn—first on the left side and the second to the right—both having the same distance from the equilibrium line with their corresponding distances being based on past price volatility.



The result is the channel with a lower and an upper half.

The Linear Regression of Time and Price


How to use linear regression channel

You use a channel based on the linear regression line the same way that you use a hand-drawn support and resistance channel, as you can see in the following sections.

Linear regression channel is used the same way that one would a simpler support and resistance channel.

One can predict the future price range by simply projecting the lines out into the future and any significant breakout is deemed to be the end of the trend.

A regular support and resistance channel are defined by the outer boundaries.

There is no centerline.

The linear regression channel is constructed from the inside out.

One begins with a center linear line and from that plots the outer lines.

Linear Regression Channel


More accurate way of drawing a linear regression channel

The accuracy of the linear regression channel depends on where one starts plotting.


An obvious low or high is a good point from where to start a linear regression channel – a trend line is drawn from there to a second relative low or high, and then extended out.

The parallel line is then added, which will assist in adjusting the slope by incorporating relative highs or lows that were missed at first.



One way to know that the channel line is plotted accurately is when a third relative high or low touches the line but doesn’t cross it.


How is it different?


The linear regression channel is used the same way as a regular channel — to get an idea of the future price range and to discover when a trend has ended by noticing a break of one of the trend lines.


The linear regression is different in one respect, though.

It doesn’t contain every price extreme in a series.

It includes a high percentage of them.

Therefore, there will be price bars that break the trend line without invalidating the linear regression channel, unlike the regular channel.



How to interpret linear regression channels?

While trying to predict tomorrow’s prices, one answer might be "relatively near to today's price."

A more accurate conjecture would be "relatively close to today's price with an upward bias" if the price were trending up.

Here’s the point.

Linear regression offers the statistical validation of these logical assumptions.

The least squares fit method is used to plot the Linear Regression trend line in the exact middle of the prices any movement above or below would indicate overaggressive sellers or buyers.


A popular way of using the linear regression trendline is to build Linear Regression Channel, which consists of two parallel, equidistant lines to the left and to the right of a Linear Regression trendline.

The distance between the regression line and the channel trend lines represents the maximum interval between any closing price and the linear regression.



Linear Regression Channels incorporate price movement, with the right line providing support and the left channel line providing resistance, with understanding that for a short period of time, prices may extend outside of the channel.

However, a reversal in trend may be forthcoming if prices remain outside the channel for the extended period of time.


While the prices occasionally venture outside their boundaries, these extremes are routinely corrected, which means that these outliers may be considered as special selling or buying opportunities.


Summary

Linear Regression Channels are useful tools simultaneously providing various worthwhile pieces of information:

  1. They display the direction of the current trend.
  2. The channel breadth is determined by the level of price volatility.
  3. The length of the channel is ameasure of trend endurance
  4. The channel trend lines and centerline represent support/resistance lines in motion.
  5. A possible trend reversal is signaled by the significant break of the channel boundaries.

Try It Yourself

After all the sides of the indicator were revealed, it is right the time for you to try either it will become your tool #1 for trading.

In order to try the indicator performance alone or in the combination with other ones, you can use Forex Tester with the historical data that comes along with the program.

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