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 LRC

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.

  1. Enter a “short” trade below the low of the breakdown bar at 798.5.
  2. Place a “stop” order to protect the short at 801.2.
  3. 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 LRC

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.

  1. Enter a “long” trade at one tick above the “high” of breakout bar at 795.
  2. Place a “stop” order below the low of LRC at 793.
  3. Set the target (previous range, AB=CD) at 797.