How to Use Regression Channels to Aid in Trade Selection and Analysis
Cory Mitchell, CMT
A regression channel is a technical analysis tool that encompasses most of the price action between two given points.
Since the channel incorporates most of the price action, when the price nears the top or bottom of the channel, it indicates that the price may meet resistance or support.
Regression channels are not meant to forecast exact highs or lows, rather they simply notify a trader that the price has entered an area where the price has tended to move higher or lower from in the past.
The trader can then use other methods to find an exact entry point and stop loss level.
Regression channels also help with establishing profit targets. For example, if the price bounces off the bottom of a particular channel, it could rally toward the top of the channel.
How to Draw A Regression Channel
Like a trendline, a regression channel should be drawn over an area that encompasses at least two swing lows, and/or two swing highs.
A regression channel is drawn between any two points selected. The tools will automatically calculate the line of best fit, or the path that encompasses the most price action between the two points.
Note that I have selected two points which cover an area where the price looks to be moving in a channel. The price is oscillating up and down rather rhythmically.
A regression channel is an optional tool. If the price action doesn't seem to align with the regression channel, don't try to use it! We can't force the market to align with our indicator. They will align quite often, but if the price is not moving in a rhythmic way, then the tool may not be useful.
Below is how the channel looks once the two points are selected.
Click on the channel to determine how wide the channel is. I have this one set to 1.75 deviations. A larger number will widen the channel, while a smaller number will narrow the channel.
In the example above, we have drawn one channel over a long period of time.
But we can also use the regression tool in real-time, updating the channel as the price moves. For example, back in September or October of 2018 the channel would have been much smaller, based on the price action so far, but over time the oscillating price action continued and the channel could be continually extended (match the endpoint to recent price bar).
We can also draw multiple channels over smaller segments in the price. In the example below the rising price action within the larger channel has a channel applied to it, as well as the decline off the top of the big channel.
Once a channel is no longer relevant, delete it.
How to Use Regression Channels
I use regression channels to highlight possibly important support and resistance areas, which then may translate into possible trades.
Consider the EURUSD rise in late 2019. The EURUSD has reached the top of its short-term rising channel, and it also just slightly above the top of a long-term descending channel. We could call this a double resistance area, where we are at the top of two channels, one short-term and one longer-term.
The price being a bit above or below a channel line doesn't matter. The channels are just meant to alert us to an important area.
This is a good area to go short, assuming you believe the long-term (big) descending channel will remain intact. In this case, you are looking for a drop back to the bottom of the channel. That drop, which played out, is highlighted by the smaller descending channel.
Regression channels may also aid in setting profit targets. A longer-term trader may target the bottom of the big channel after going short near the top.
A shorter-term trader may target the bottom of the rising channel after going short, for example.
Stop losses are discussed in Using Stop Losses and Where to Place Them.
Regression Channel Considerations
The regression tool shows where most of the price action happened. It won't capture extreme highs or lows. Its power is in showing where the price typically/historically reverses.
The channel indicates areas of interest, not exact levels.
Extending the channel out to the right highlights areas of possible future interest.
The wider the channel the more price action the channel will encompass. This may be good for highlighting extreme areas, but you will miss lots of the reversals that don't occur at such high/low/extreme levels (they occur inside the channel).
Regression channels can provide an overall context for how the price is moving.
Regression channels are based on two fixed points, which means they need to be updated at price action unfolds. They are still useful though, as even with updating some channels will change very little, providing tradeable areas for long periods time.
If a channel is no longer useful, or doesn't really suit the price action, delete it.
Remember YOUR trade timeframe. If you are a day trader or short-term swing trader, focus on channels that last hours, days or weeks. If you are a longer-term trader, focus on channels that last months or years.
We want the regression channel(s) to improve our analysis and ultimately our profits. If it doesn't aid you in that regard, don't use it. Some people find it visually appealing and it helps them in their trade selection. For others, it may not help. It is an optional tool. This is not a recommendation to use it.
By Cory Mitchell, CMT. Join me in my free Facebook Trading Group.
Disclaimer: Nothing in this article is personal investment advice, or advice to buy or sell anything. Trading is risky and can result in substantial losses, even more than deposited if using leverage.