A “Linear Regression Channel” (LRC) is created by drawing an equal Standard Deviation (SD) distance from the “Linear Regression” based trend line. A “Linear regression” trend line shows equilibrium prices, where as “Linear regression” channels show the deviation of prices from the equilibrium or center line. A “Linear regression” channel is plotted on the price chart using the least squares method. In a LRC, the bottom channel indicates support and the top trend line indicates resistance. Prices trade within the LRC, and when prices exceed the upper or lower trend line, it signals a potential reversal. If the prices continue to close outside the LRC for about half of LRC length bars, then it may be signaling a trend change and a potential formation of a new LRC. Many traders use LRCs with the price-action to find key entrylexit trading opportunities.
Trade: Wait for a LRC to form for at least 12-15 bars. Price closing outside the LRC suggests potential breakout/breakdowns. Traders enter above the high of the breakout bar for a “long” trade and below the low of the breakdown bar for a “short” trade.
Target: The range prior to the LRC formation would be the target from the breakout or breakdown level.
Stop: Place a “stop” order 1 tick above the high of the LRC for “short” trades and 1 tick below the low of LRC for “long” trades.
Trading Linear Regression Channel Breakdowns
The chart above shows a LRC pattern from the Russell Emini (ER2) 610 tick chart. On Jan. 16,2007, ER2 sold off during the morning trade and closed near 798. At lunch hour, ER2 formed a LRC from 798 to 801 as prices tried to recover and traded higher. Around 12 pm, ER2 continued its prior down trend and closed below the LRC.
- Enter a “short” trade below the low of the breakdown bar at 798.5.
- Place a “stop” order to protect the short at 801.2.
- The previous range prior to the LRC formation is set as the target range. The prior range is from 805 to 798. Subtract this range from level C at 801. The target is set at 794.
Trading Linear Regression Channel Breakout
The example above shows a LRC breakout from the ER2 610 tick chart. On January 17, 2007, ER2 formed a LRC at about 1 lam, where prices closed outside the LRC signaling a long trade at 795.
- Enter a “long” trade at one tick above the “high” of breakout bar at 795.
- Place a “stop” order below the low of LRC at 793.
- Set the target (previous range, AB=CD) at 797.