By Richard L. Muehlberg*
Posted: March 7, 2008
Have you ever seen a price move without having any idea why it moved the way it did at exactly that moment? There are moments when trading can feel like a throw of the dice. It is as if other traders are watching "invisible lines in the sky" that tell them what and when to buy and sell; they can see these indicators, but you can't. No doubt you are constantly looking for ways to improve your ability to know why and how prices move. You look to find these secret lines.
What are the tools you use now? eSignal offers a full spectrum of analytical studies. Each has a varying degree of popularity among traders and investors. Some traders swear by the study or studies they follow. Other traders shift from study to study. Others still use nothing but a recommendation, a hunch, or a feeling to make trades. I have, at one time or another over the years, been all of these traders.
Early on, I learned that most basic of indicators: the trendline. A simple trendline is a line drawn across the price lows in an uptrend and across the highs in a downtrend. In time, I came across price channels. A channel combines two trendlines. One line is drawn across the lows, and a second line is drawn across the highs whether the price is trending higher or lower.
Then, I came across one of the orphans of analytical studies: The linear regression channel. eSignal is one of the few charting services, to my knowledge, that offers the ability to chart linear regression channels. I say "orphan" because many traders do not even know what linear regression channels are. Two years in a row, I attended a major exposition for traders and asked a variety of providers / vendors if they offered or had even heard of linear regression channels. I got blank stares.
From the moment I saw linear regression channels in action, I was fascinated by this orphan. A price channel is combined with a mean or centerline. This centerline is equidistant from the lower (buy) line and the upper (sell) line. The channel's width and the channel's inclination or declination change as the price changes. In other words, price action dictates the channel's width and aspect. What is fascinating about linear regression channels is how often a channel dictates price action.
I have included a NASDAQ 100 chart with this article. The chart covers an 11-day period using 180-minute price bars. The chart's rightmost day is November 30, 2007. The chart's upper line is the sell line. The center line is the mean and the lower line is the buy line. A theory of linear regression analysis is that prices trend along channels, often testing the extremes of the channel to the upside and downside and often returning or regressing to the mean before resuming their exploration of the extremes.
That is the theory. There are problems with linear regression channels, just as there are problems with all analytical studies. There are the basic questions of how many channels should you use to cover a particular market … what time periods should you use…should you use price bars or candlesticks or whatever… etc. The questions are, in my experience, best answered through experimentation.
At this point, you may be thinking to yourself, "Yeah, right." Before, however, you dismiss the use of linear regression channels, these "lines in the sky", take a closer look at the NASDAQ 100 chart I have provided. Take a closer look at the rightmost day, November 30, 2007.
On November 30, the NASDAQ 100 was entering the third day of a sharp run. So, what happened next? The rally evaporated at 9:30 a.m. Eastern with the opening of the New York Stock Exchange. The price broke off the 11-day sell-line. Where did the price go? It broke to the 11-day mean, then rallied with pinpoint precision.
There were a lot of explanations for why the NASDAQ 100 behaved as it did on November 30, but did you hear this explanation: "The NASDAQ 100's current rally was resisted today at its 11-day, bull, sell line. After a sharp break, buyers became aggressive in the afternoon at the 11-day mean."
Have you ever seen a price move without having any idea why it moved the way it did at exactly that moment? Other traders knew. You need to learn what they know or find a way to duplicate what they know. I hope this brief article encourages you to learn more about linear regression channels.
There is certainly more to learn. Open a new eSignal chart. Pick any futures or exchange-traded fund or stock. Now, go to the analytical studies and choose "linear regression". Start experimenting. See what you see.
*Reprinted (and modified) with permission from Richard L. Muehlberg (firstname.lastname@example.org), full-time trader and online publisher, www.DayTradingWithLinesInTheSky.com