How To Trade - Linear Regression Channel

Similar to the 200-day Moving Average, large institutions often look at long term Linear Regression Channels. A Linear Regression Channel consists of three parts:

1. Linear Regression Line: A line that best fits all the data points of interest.
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:

1. Buy or sell opportunities are present.
2. Or the prior trend could be ending.

Linear Regression Channel Buy Signal

When price falls below the lower channel line, a buy signal is usually triggered.

Linear Regression Channel Sell Signal

An opportunity for selling occurs when prices break above the upper channel line.

Other confirmation signs like prices closing back inside the linear regression channel could be used to initiate buy or sell orders. Also, other technical indicators should 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.

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