Draws channel using Linear Regression of Close prices.
Can optionally display Center of Channel (Mean), Edges (maximum Deviation) and Standard Deviation.
Color and Line thickness are also Customizable.
Similar to the 200-day Moving Average, large institutions often look at long term Linear Regression Channels.
A Linear Regression Channel consists of three part's :
1. Linear Regression Line: A line that best fits all the data points of interest. For more information, see: Linear Regression Line.
2. Upper Channel Line: A line that runs parallel to the Linear Regression Line and is usually one to two standard deviations above the Linear Regression Line.
3. Lower Channel Line: This line runs parallel to the Linear Regression Line and is usually one to two standard deviations below the Linear Regression Line.
The multi-year chart of the S&P 500 exchange traded fund (SPY) shows prices in a steady uptrend and maintaining in a tight one standard deviation Linear Regression Channel :
The upper and lower channel lines contain between themselves either 68% of all prices (if 1 standard deviation is used) or 95% of all prices (if 2 standard deviations are used). When prices break outside of the channels, either :
Buy or Sell opportunities are present. Or the prior trend could be ending.
Linear Regression Channel Possible Buy Signal
When price falls below the lower Channel line, and a trader expects a continuation of the trend, then a trader might consider it as a buy signal.
Linear Regression Channel Possible Sell Signal
An opportunity for selling might occur when prices break above the upper Channel line, but a continuation of the trend is expected by the trader.
Other confirmation signs like prices closing back inside the Linear Regression Channel might be used to initiate potential buy or sell orders.
Also, other technical indicators might be used to confirm.
Trend Reversals
When price closes outside of the Linear Regression Channel for long periods of time, this is often interpreted as an early signal that the past price trend may be breaking and a significant reversal might be near.
Linear Regression Channels are quite useful technical analysis charting tools. In addition to identifying trends and trend direction, the use of standard deviation gives traders ideas as to when prices are becoming overbought or oversold relative to the long term trend.
Linear Regression Line
A Linear Regression Line is a straight line that best fits the prices between a starting price point and an ending price point.
A "best fit" means that a line is constructed where there is the least amount of space between the price points and the actual Linear Regression Line.
The Linear Regression Line is mainly used to determine trend direction. A chart of AT&T (T) stock is given below :
Traders usually view the Linear Regression Line as the fair value price for the future, stock, or forex currency pair. When prices deviate above or below, traders may expect prices to go back towards the Linear Regression Line.
As a consequence, when prices are below the Linear Regression Line, this could be viewed by some traders as a good time to buy, and when prices are above the Linear Regression Line, a trader might sell. Of course other technical indicators would be used to confirm these inexact buy and sell signals.
A useful technical analysis charting indicator that uses a Linear Regression Line is the Linear Regression Channel (see: Linear Regression Channel), which gives more objective potential buy and sell signals based on price volatility.
