Hello, We’re gonna look at how to trade the linear regression channel with ease. Don’t panic! We’re not doing Michael Jackson’s moonwalk here. We’re going to look at an important trading tool called the regression channel. This tool is very popular among forex traders as far as price action analysis is concerned.
Without wasting too much time,we’re gonna do the following: We’re going to look at what this regression channel is all about. Then we’ll transition into looking at the three lines that make up the regression channel,and finally we’ll end with how to trade the regression channel. But first,
What exactly is a Linear Regression Channel?
Well a linear regression channel is a technical indicator consisting of three lines. Well, that’s not all,if that’s what you’re thinking. The linear regression channel outlines the upper and lower limits of a live trend. It helps traders hunt for the best entry and exit points available even if the price gives traders mixed signals. Which brings us to:
Structure of the Linear Regression Channel
Now the linear regression channel is structured in three parts namely, the Upper linear regression line, the lower linear regression line, and median . Now the upper linear regression line signifies the top of a live trend with the lower and middle line lines running parallel with the linear regression line.
The lower linear regression line is pretty self-explanatory. The lower linear regression line marks the bottom of a trend.Now how does the lower linear regression line come about? The lower linear line comes about by cutting through the most obvious bottom trough of the trend. Of course the upper and middle lines trudge along as they run parallel with the lower linear regression line.
Last but not least, the median line is what we’d call the base of the linear regression channel. It’s more like the conduit of the entire regression trading process in that it is draws the midpoint of a trend. So to avoid colliding head on with this trend the upper and lower lines are evenly distanced. They keep as far away from the midpoint as possible. Let’s see the Linear Regression channel in action
There you have it. The linear regression channel indicator in all its splendor. You can see the upper line, lower line and median line, all nicely lined up. The black arrows point to the top and bottom projecting the most in the trend. While, of course, the three blue lines point nice to the upper lower and median lines.
Now there are two types of regression channels- namely the bullish and the bearish regression channels. These two channels have built their reputations based on the linear regression slope. We’re going to take close look at both regression channels.
Bullish Regression Channel
The bullish regression channel makes itself known on bullish trends. When you see the bullish regression channel setting up shop, that should tell you two things: price is increasing, and the slope is heading upwards. Let’s see the bullish regression channel in action
Ladies and gentlemen, here is the is the bullish regression channel in the flesh. As you can see, the trend is bullish with the bulls in full flight with the regression channel in an upward slope.
Last but not least is:
Bearish Regression Channel
The bearish regression channel is the complete opposite of its sibling the bullish channel. Unlike the bullish channel, the bearish channel makes its home on bearish trends. In this scenario,the bears drive down the price, causing the slope of the linear regression to dive downwards. So basically everything is slaloming downwards in the bearish scenario. Let’s see the bearish regression channel in action.
This is none other than the bearish channel. As you can see the trend is bearish. And when you have a bearish situation,it can only mean one thing:the bears have come out to play. And when this happens, the channel slopes downward as illustrated above.
I guess the question burning on everybody’s mind is:
How Do We Draw The Linear Regression Channel?
There is not much to it. Just draw the linear regression channel.Okay, on a serious note, pick the starting point of a trend and stretch the regression indicator for all its worth until it reaches and touch another significant point of the trend. Meanwhile,the three lines will correct themselves according to the most obvious top and bottom of the trend.Let’s see the drawing of the regression channel in action.
Right in front of us is the live drawing of the regression channels in an uptrend. And as you can see, the regression channel(on the left) starts from the bottom of the uptrend and touches the engulfed candle at the top of the uptrend. A word of warning though. Dont ever force a regression channel to fit a trend. Do so at your peril.
What to Look For in Regression Line Analysis
Now that we’ve drawn our three lines, it time to analyze these lines. The main feature you need to keep your eye out for when analyzing regression lines is price reaching out and touching these lines. Whenever price caresses the upper or lower line a sea change occurs on the chart, be it uptrend or downtrend. And like I said,the three lines tend to correct themselves depending on how prominent the tops and bottoms of the trend are. Let’s take a look at such an illustration in an uptrend
We’re looking at price action in a bullish regression channel. The black arrows at the bottom of the channel indicates the price action being contained within the channel.
Now let’s take a closer look a the lower line of the regression channel indicator. If you have the vision of the hawk, you’d notice a trading opportunity through the freshly created bottom on the lower line. And guess what your trading position should be:GO LONG OF COURSE. This is a bullish trend,and naturally your trading inclination would be to go long. You should be able to ride the trend’s momentum until you reach the top of the trend where the other black arrow is situated.
Take a closer look at the lower line, and you see a major reversal taken place. The bears have taken over the show after putting so much pressure on the bulls. They’re basically saying “Anybody for a slalom ride?” Also take a close look at the pin bar formation followed almost immediately by another bear breakout at the low regression line. And if you want to know more about the pin bar formation,check up on Pin Bar Strategy – How To Trade It.
I guess the question everybody is burning to know is:
How Do I Enter Linear Regression Trade?
Well if you’re dealing with a bullish trend, buy the pair once the price ricochets (bounces) a second time off the lower line of the regression indicator. The second bottom at the lower line should signify the uptrend and announce the bulls presence. Therefore make your trade at this time, while the bulls’surge is on.
See how the second bottom forms at the lower line where the second black arrow is pointing. Make your trade once price bounces off that area.You would most certainly want to take advantage of this bullish surge while you can.
I guess the next appropriate question will be:
How Do I Enter Bearish Linear Regression Trade
Well entering a bearish linear regression trade works similarly to that of entering a bullish trade. The only difference being that the bearish regression trade works in reverse.By reverse,I mean a reversal occurs with the bears dominating things Let’s take a look at the situation.You can enter your trade at the second bounce going down instead of going up-.See how the second bottom forms at the lower line.Except that it forms towards the end of the slope,instead of the beginning. And just like I said for the bullish trend, you absolutely want to take advantage of this bearish slalom while you can.
Worried about safeguarding your trading position? I guess your question will be:
Where Do I Place My Stop Loss?
Before I even get started,you’d be crazy not to place a stop loss when trading linear regression channels. Your trading account wont forgive you for such negligence. But anyways, back to the question: Well, if you are trading a bullish linear regression setup below the high created by the high bounce from the upper line of the regression indicator.
Going the opposite direction, if you are trading a bearish setup, place your stop loss above the high created by the high ricochet from that same upper line of the regression indicator. Let’s take a look at a bullish linear regression channel illustration.
As you can see this is a bullish line regression channel.Take a close at the two bottoms labelled numbers 1 and 2. These two bullish candles create the regression channel indicator. Such that when price takes a high bounce for the second time,we connect the two bottoms, using the regressive indicator and prepare to go long(buy). However, to protect your trade against an unexpected U-turn by the market, place a stop loss below the new low.
However, some serious action is taking place at the median line(middle line). The bulls surge through the medial line, creating a swing in the process. Then the price,with the help of the bulls expand to the upper and lpper level. And when that happens, listen to that little inner voice when it says “Close Your Trade.”
Watch the second trade form when the bulls reach the lower backyard of the regression channel. The bullish candle goes up a notch once after touching the lower line and bouncing off the lower line. Look to enter a trade and then place your stop loss below the freshly created bottom.
Once the bulls bounce off the line ,see how these head for the hills and manage to reach the upper echelon of the Linear Regression Indicator with rapid speed. Once the bulls reach the upper line,it’s time to close the trade.
However, much to our surprise the unexpected happens. The price makes a U-turn back to the lower line o the Linear Regression Indicator. Notice the price bounce off the lower line again. What does this mean?It means we’;ll have to go through the process all over again. We buy the currency pair and place our precious stop loss below,you guessed it, the freshly created bottom. Then we hold our horses until the bulls reach the upper echelon(level) of the linear regression indicator.
Take Profit Rules In Linear Regression Channel
The way I see it, you have two options as far as take profits trading the linear regression channel is concerned. First,you can put your trade on hold until the price hits the opposite Linear Regression level, as discussed earlier.
The second option would be to hold your trading horse until the price action pierces the median(middle line) opposite the dominant trade. What does it mean? If you decide to go long, until the price breaks the median line and heads downwards. But if you decide to close the trade when price dips below the median line and heads for the hills.
Oh, and by the way! You’d be committing suicide If your trades ares till open when the price break the channel in the opposite trend. If a breakout occurs, just close your trade and get ready for the countertrend.
Now let’s look at a an illustration of these take profit rules using a bearish linear regression example
The two numbered points are the bases of the Linear Regression Channel. See how price bounces off the upper line for a second time. /In such a scenario, look to go short. You then protect your trading position with a stop loss above the freshly created top, as indicated by the red horizontal line.
Also ,see how price takes a dip and goes below the median line. Since you want to protect your trading position at all costs, you’d do well to close the trade once the bulls break the median line from below.
And , just like the bullish regression line example,earlier, price comes back to hit the upper echelon of the linear regression . This bearish bounce off the upper line suggests that you enter a short trade, and, you guessed it, placing a stop loss above the freshly created top.
Take a close look at price dipping below the median line and touching the lower level. If you’re tempted to jump into the fray,DON’T! Wait until price makes a switch above the median line and then close the trade.
Have you noticed how the bears came back to create another bounce by hitting the median line for the third time? Seems the bears enjoy this hit and run tactics. Don’t they? Unfortunately you’d have to sell the currency pair and place a stop loss as the image suggests.
If you want to know some more about trading channels look up We Are Going To Talk Channels.
That’s a wrap for “How To Trade The Linear Regression Channel With Ease. ” As I said earlier, trading the linear regression channel is very valuable to traders as a price action analysis too. You can sure get some exciting trades using this tool even if the market tries to throw you off the tangent. Once you catch these opportunities on the regression channel, you are good to go.
Til next time take care.
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