January 27, 2006, Newsletter Issue #3: What is a Regression Channel Analysis?

Tip of the Week

A regression channel is a product of a statistical analysis process called linear regression. In short, a "best fit" line is drawn through the middle of a set of data points encompassing a specific period from the day of a significant low to the day of a significant high (or vice versa). The slope of this line, called the midpoint, reveals the nature of the trend. We prefer to find situations where the midpoint line is significantly sloped either up or down. This alone heightens the odds for directional movement.

The next step in our analysis is to use charting software to automatically draw parallel lines above and below the midpoint line. These parallel lines are connected to significant lows and highs and these reference points help form our regression channel. The regression channel also acts as a kind of standard deviation, with the middle line acting as a median. From this, we make note of whether the stock gravitates toward the lower or the upper end of the channel. In short, regression channels simply provide a clear picture of the equity´s overall trend.

The idea behind regression methodology is to build a channel around the price data of a security and then project that channel forward in time. It is this projected portion of the channel that generates trades.

Regression Channel Chart of Calpine (CPN):

Breaks outside the channel are often a sign that either a more accelerated trend is in store or a reversal in trend has developed. If the breakout holds, it is often advantageous to trade the direction of the break.

As stated above, these channels are based off a regression line, which is calculated using the sum of the least squares method. The actual number crunching is not that important because there are a number of software charting packages that will perform the calculations. rend.

Regression Line:

While this mathematical calculation identifies the slope of a trend, it is critical to first identify the starting point and ending point of the data to be examined. In order to begin a channel, a significant low must be identified. The term "significant" allows a great deal of flexibility in applying this methodology, which can be adapted to a variety of trading needs. Short-term traders, for example, can create daily or intraday channels. Longer-term traders can draw channels on weekly and monthly charts. Neither style is more "correct" than the other, as each fits different trading styles.

Most traders look at regression channels with an eye toward selling near the top of the channel and buying near the bottom of the channel. What we´ve found is that the most powerful period for traders is when the stock actually breaks out above or below an existing channel, as this tends to imply a more steeply sloped, accelerated uptrend or downtrend for the stock over the next few days or weeks.

On the bullish side, a stock that breaks out above the top regression line within an uptrending channel should be purchased on the first pullback that touches that line. The odds suggest that this former resistance line is now support, and an opportunity often appears amid a sharp pullback. If the stock dips below this rail, it is often an indication that the near-term rally has subsided, and is a signal to exit the trade.

On the bearish side, when a stock breaks down below the low end of an uptrending regression channel, the short-term consequences are usually a run for the exits by investors. Conversely, if the stock breaks back into the regression channel, it is often an indicator that the stock´s selling power has somewhat evaporated, and signals an exit from a bearish position.

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