Overview of Regression Trend Channel (RTC)

[MR]

Overview of Regression Trend Channel (RTC)
by Marc Rinehart


Since the early days of technical analysis the use of a "trendline" has been an acceptable technique to help define price support and/or resistance. One form of a trendline developed from higher level mathematics is known as a "linear regression trendline.

A linear regression trendline is the straight line mathematical measurement of the relationship between sets of price data that plot out as a trendline.



In many ways it is similar to a moving average. The difference is there is no lagging the linear regression trendline and, secondly, it is helpful because it often identifies a change in trend quicker than a moving average.

According to theory, prices can vacillate above and below the regression trendline and still the overall trend is maintained. By using the Regression Trend Channel (RTC) you can better identify that outer range of that overall trend pattern.

A Regression Trend Channel (RTC) is simply the mathematically standard deviation of the linear regression price data. It is calculated using the actual prices of the bars in the trend. The idea is to draw an upper and lower channel from the linear regression line by using the standard deviation of the prices. The break of a Regression Trend Channel is usually used as an entry or exit signal.



The RTC is similar to Bollinger Bands which draw bands using standard deviations of a moving average. However, instead of using a moving average, by using the RTC tool, Advanced GET is simply allowing you to use the linear regression line of a swing you identify. (In case you where wondering, the Advanced GET RTC uses the data bar midpoint for its calculation.)

Find the Regression Trend Channel (RTC) in the Advanced GET studies selection or highlight the RTC icon. To activate the RTC default menu, click your right mouse button.



The Advanced GET defaults the trendline source to "High-Low flip." The H-L flip indicates that the Automatic Trend Channels should be calculated using the Low of the bars when the trend is up, and the High of the bars when the trend is down. Our studies indicate the H-L flip generates the best regression trendline. You can change to a different calculation method if you have a different preference.

The program also defaults with the Standard Deviation turned "On" for the Upper and Lower Channel. With the standard deviations checked off you will no longer have a regression trend channel, but you could use this tool as a channeling technique. We prefer the standard deviation to be turned "On."

The "End Bar" is a useful selection in the RTC menu that allows you to have a visual reference or reminder of where the ending calculation is on the RTC. For example, say you are calculating the early stages of a new sequence using the RTC tool. By turning "On" the "end bar" you will see a vertical line in that RTC. You also have the option to change this identification point to any color you select. Later, if you want to recalculate a new RTC based on current action, you now will have a reminder of where those RTC's calculations were taken from. This is also a useful feature when you are using multiple Regression Trend Channel lines when interpreting price action.

The "Pearson's R" On/Off button indicates if the Pearson's value will be shown at the end of the Regression Trend Channel. Showing Pearson's value helps identify the "slope" in the price movement.



As the Pearson's R value gets closer to the value of 1, the calculated trend line is matching the actual value of the data. In most instances a very high Pearson's value will be identifying the desirable "single slope" price movement we should be monitoring for as Advanced GET users. This means that the regression line is "fitting" the trend very well. As the Pearson's R value gets closer to the value of 0, the trend line is doing a poor job at matching the data action. This means that the regression line does not "fit" the trend very well. However, a low Pearson's may still be useful if you want to help identify the potential outer ranges of price movements in a non-trending market, or wider swing movements. Think of the "Pearson's R" value as a percentage-- a 0.900 (90 percent) match is a good fit; while a 0.060 (6 percent) match is very poor.



If you use the RTC enough you tend not to use the Pearson's feature because they can help clutter a screen and you can pretty much guess at the "fit" when you see them enough times.

The most effective use of the Regression Trend Channel (RTC) would be when a "single sloped" market is identified (in simple terms: when a market that is moving in a very linear manner) to begin to apply the RTC for a potential breakout pattern. The use of Pearson's helps identify that linear relationship. If a market is "curve fitting" well-- some would say a Pearson's value of 0.90 to 0.93, or greater, is what you want to see for a "tight fit"-- you can now begin to setup for a trade opportunity of the break of channel line in that tight fit.

As Advanced GET users we want to be monitoring for Elliott Wave Type One and Two Buy or Sell trading opportunities. The question to ask: "Is the Type One or Two pattern moving in a straight line advance or decline, or not?" If it is, use the RTC to help confirm the trade opportunity. If the price is not moving in a single slope, then use the 6/4 DMA's to confirm the trade setup.

In a Type One setup the RTC calculation begins at the end of a major Wave Three and should end at the current major Wave Four. In a Type Two setup you want to focus your calculation on the major Wave Four to the current high.





It is important to remember you will always increase the probability of success for your trading opportunity when you combine the use of the RTC with other Advanced GET tools, such as the Oscillators, MOB, Ellipse, XTL, and so forth.

Before ending, let me share with you a few experimental ideas you may want to try on new uses of the Regression Trend Channel tool in Advanced GET:

(1.) When you see a Type One or Two setup where you are using a Regression Trend Channel, try re-issuing that chart to a lower time frame to better frame up the trade opportunity. For example, take a look at again at the Disney Type One buy opportunity setup on the Daily chart. Now, either issue to a new Hourly chart, or re-issue the Daily to an Hourly and calculate a new RTC from this new time frame. By applying this cross-referencing technique you may be better able to identify a breakout entry point more quickly, one which has improved risk/reward parameters.

[MR]

(2.) If you have a market that has been trending in strong or down sequence-- what some might call a "momentum" play-- try taking your RTC and calculate from the beginning to the current end. You may be able to use the RTC-- in conjunction with a MOB, Ellipse, Elliott Oscillator, XTL, the 6/4 DMA's, and Advanced GET other tools-- to help stay with a winning trade and help identify either that sequence's break point area or the next possible good risk/reward trend setup. When you look at the July '00 Daily Corn chart you could have easily identified a trading Short opportunity and combined tools with the RTC to stay Short from early in that breakdown sequence.



(3.) There are times when you might want to combine the RTC and 6/4 DMA's to gain a better handle on price movement, even if the price is moving in a single sloped direction. If the trend direction is to continue, one tool might get broken, but not both. While you should still only take a signal off one tool, the other can help confirm. Again, looking at the recent July '00 Daily Corn chart helps illustrate this idea. Using both the RTC and 6/4 DMA would have given you greater confidence in staying with the downtrend. The key is not to use both tools when they begin to clutter your screen and reduce your ability to act quickly breaks do not occur.

(4.) When you have a clearly defined RTC-- preferably with a single slope-- and you are not trading the swings within the channel, why not turn "Off" everything accept the breakout Regression Trend Channel line? By so doing this the screen becomes less cluttered and is now made more useful for other analysis with other tools. For example, if you are in an uptrend, go to the RTC menu and turn off everything but the Lower Channel setting, using a break as a signal to either lock in profits, or reevaluate a position. Do the same thing with a downtrend, turning off all but the Upper Channel setting.





(5.) Finally, before ending, let me share with you an experimental RTC tool technique I am using now to help me refine my risk/reward entries. It seems to be reaping good results.

A while back I became to recognize a reoccurring pattern when using the Regression Trend Channel as an entry tool. Often there will be "spikes" where the price trades outside the channel, only to pull back within the channel formation, continuing in the overall trend direction. I started experimenting with the standard deviation selection in the RTC menu, and after a while I found out I could actually "tweak" the settings and take advantage of these "spikes." While experimenting with the standard deviation setting that would now include those "spikes," then what would subsequently be spikes later on in that sequence were now contained in the RTC. The caveat rule I developed in this new technique is this: if it is an uptrend, I only adjust the upper channel, never the lower channel. If it is a downtrend, I will adjust only the downtrend channel, never the upper channel. The breakout signals remain the same, but the spikes are now included in the total pattern. The adjusted channel would now serve as a better visual guide when placing a stop loss on a trade.

In addition to this RTC adjusting technique, I first use the other tools and techniques available within Advanced GET to help better define the trading opportunity setup, but now I can better use the RTC-- in many instances-- to help me better guess an entry and stop placement, which has always been one of my weaknesses. Whether you believe this or not, it does seem to really help me with difficult stop placements and I will be continuing to search for improvements in this technique.

To better understand this idea, look at the September '99 Daily Lumber contract illustration.



Lumber was in an uptrend at the time. It stayed contained in the Regression Trend Channel until late June of '99, then "spiked" through only to fade back into the channel. After adjusting the Upper Channel value in the Regression Trend Channel menu I was able to find a setting that now included that "spiking" action. I used that setting. Whatever my reason for going short at the time I cannot now clearly remember, but I did use just the adjusted RTC and a MOB and was better able to define a safer, more manageable risk/reward that worked out well.





Again, this is only a technique I have been playing with, but it seems to be working well. The use of the Regression Trend Channel (RTC) in Advanced GET has become one of many unique tools available within the program that has improved my own personal performance. If you are not currently using Regression Trend Channels in your analysis, you are missing a powerful tool in your trading arsenal.

[MR]

PART TWO, more on Linear Regression Channel Tool....

Enhancing the Use of eSignal “Basic Studies- Linear Regression” Using Advanced GET Tools and Studies

I was asked a while back to develop a series of trading strategies for those using just the eSignal “Basic Studies” tools. The first trading strategy uses the eSignal “Basic Studies-- Linear Regression” tool. I want to share this very simple strategy with Advanced GET users because if you review it, and then try to build into it an understanding of Advanced GET techniques, I think this very simple trading idea will have even greater merit. Remember, this is NOT the same Advanced GET Linear Regression Channel tool, but rather a more simplified “Linear Regression” algorithm located at the “Basic Studies” menu in the eSignal software. There are some variations in the two. The Advanced GET has some added enhancements. Again, the Basic Studies-- Linear Regression strategy is just a very simple approach to using a linear regression channel that does not take advantage of the Advanced GET enhancements. Add AGET and you may find another nice idea for trading setups.

(The next several posts will address will be a review and intro to this RTC idea.)

Linear Regression is an eSignal Basic Studies charting tool using the least-squares fit mathematical method to statistically plot a “best-fit” straight line through the exact middle of the prices over a given period of time. A Linear Regression trendline shows where an equilibrium or mid-point price exists.

GENERAL OVERVIEW OF THE LINEAR REGRESSION TOOL

Linear Regression identifies when prices overextend from a median point. The distance a price migrates above or below a linear regression line indicates the extreme buying or selling perspective from the average point.

The slope of the line is called the midpoint or median line. The midpoint or slope of a line is determined by the calculation method. In eSignal, the “close” of a data bar is the default value used for the linear regression calculation.

Linear Regression Channels are parallel lines that are a standard deviation away from the linear regression line on either side of it. These lines are also called confidence bands. They act as support and resistance lines.

Statistically, linear regression channel lines should contain price movement. The percentage of price containment depends on the standard deviation used. Prices may extend outside the channel lines for a brief time. However, if they remain outside the channel, it suggests that, either an existing trend is accelerating or a possible reversal in trend is growing.

The space inside the channel is where the equilibrium exists, where price may deviate from the linear regression line yet stay within the existing overall trend.

SETTING STANDARD DEVIATIONS

Trading effectively using Linear Regression requires setting appropriate standard deviations. Use parallel lines as support and resistance confidence bands spaced equally on either side of the regression line.

Standard deviation settings vary based on the slope of the existing trend. Experimentation suggests that a standard deviation setting of 1 is too tight for trading in normal conditions, and a setting of between 2 to 3 is effective. A setting of 5 can be used in extreme range scenarios.

In addition, the number of bars used in a calculation also determines how well the Linear Regression “fits” the immediate price trend pattern. The more data bars in a calculation, statistically speaking, the better the fit. Aggressive Number of Bar settings used include 60, 70 and 90. The eSignal default set to 0 means all data is used for a Linear Regression calculation.

While there are several ways to trade using Linear Regression Channels, this strategy focuses on using the following settings: Source = Open, Number of Bars = 0, Standard Deviation = 2.

THE eSIGNAL BASIC STUDIES LINEAR REGRESSION CHANNEL TRADING STRATEGY: THE SETUP

A simple trading strategy is to set the standard deviation to 2, look for a stock trading in a trend and trade the extreme Linear Regression Channel swings. To use this strategy, make the Linear Regression median line your first target. In a best-case scenario, use the opposite linear regression channel line as your second target. Use the outer channel lines and price pivot as an initial stop loss, trail stops appropriate to the position and, as price approaches targets, tighten your trailing stop.

NOTE: Use this setup for the Sell Strategy and the Buy Strategy described subsequently.

1. Right click on an eSignal chart to activate the main menu and select “Basic Studies” from the menu. Select “Linear Regression.”



Adjust the settings in the Linear Regression basic study window as follows: Source = Open, Number of Bars = 0, Standard Deviation = 2.



THE eSIGNAL BASIC STUDIES LINEAR REGRESSION CHANNEL TRADING STRATEGY: THE SELL STRATEGY

A.) Find a trending stock that has not exceeded the upper channel until now.
B.) Sell the extreme price swing at the upper outer linear regression channel.
C.) Place the appropriate trailing stop above the highest price bar spike at the upper channel.
(The reward potential for the risk taken should be 1.6 or greater.)



A.) Make the linear regression median line your first target.
B.) Make the lower channel line your second target if the price trades through the median line.
C.) Maintain an appropriate trailing stop for your position.
D.) Once your initial target is met, tighten your trailing stop.
E.) If the price continues through the median line and approaches the lower regression channel line,
prepare to close the position out as it exceeds initial expectations.



THE eSIGNAL BASIC STUDIES LINEAR REGRESSION CHANNEL TRADING STRATEGY: THE BUY STRATEGY

A.) Find a trending market that has a major pullback in progress.
B.) Buy the extreme price swing at the lower outer linear regression channel.
C.) Place an appropriate trailing stop below the lowest price bar spike at the lower channel.
(The reward potential for the risk taken should be 1.6 or greater.)



A.) Make the linear regression median line your first target.
B.) Make the upper channel line a secondary target if the price trades through the median line.
C.) Maintain an appropriate trailing stop for your position.
D.) Once your initial target is met, tighten your trailing stop.
E.) If the price continues through the median line and approaches the upper regression channel line, prepare to close that position out; it has exceeded expectations.



The last several posts where designed to show how one could use just the RTC tool in the eSignal Basic selection. It is only designed as a simple example. One can take this idea and experiment with different settings and design other strategies just as effective. It really is more a function of the market conditions going on, and trying to match the standard deviation setting which works best for that price pattern, be it a trend or swing move.