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How Regression Channels Can Enhance Your Trend Trading

How Regression Channels Can Enhance Your Trend Trading

2014-10-24 19:00:00
Tyler Yell, CMT, Currency Strategist
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Talking Points:

-The Benefits of Channel Trading

-Regression Channels: A Quick Explanation

-How to Trade Regression Channels

Profound truths are often rather simple truths. In terms of trading the FX market, there is a ton of different ways to find a nice trade to enter and subsequently to decide when to exit a trade. There are however, only a few ways that traders end up doing themselves harm. Of course, leverage is one way that a smart set-up can turn into a bad trade as small moves in the market which doesn’t affect the overall trend can hurt the account of the overleveraged / underfunded trader. Second, you could say that many traders try to pick the top or bottom of a move before evidence proves this to be a prudent trade.

How Regression Channels Can Enhance Your Trend Trading

The Benefits of Channel Trading

Price Channels are a simple tool to show you the overall direction a price is heading for a specific duration of your choosing. This allows you to see the big picture that many traders tend to ignore in hopes of catching “the turn”. The often seen occurrence is that the turn is rare and most corrections can be weathered with low-enough leverage without hurting your account. Overtime, this method of following the overall trend as soon-to-be-identified by the channel can outperform in-and-out trading often performed by traders thinking they can guess when the market will turn.

Regression Channels: A Quick Explanation

As channels have been explained, they’re pretty simple and you’ve likely seen them on charts before. However there are multiple channels and one specific channel type will be used today, the Regression Channel. We will walk through the differences of a regression channel and other price channels and how they can be used. However, like other methods of trading, multiple time frame analysis can be helpful as it gives you a broader outlook on what’s occurring and prevents you from being overly focused on the short-term noise of the market.

Recommended Reading: 3 Price Channels to Help You Find High Probability Trades

Learn Forex: Regression Channels are a Default Offering on Marketscope

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Chart Created by Tyler Yell, CMT

Regression channels provide you a median line followed by evenly spaced or parallel lines above and below that can act as support and resistance. The channel height will be dependent on the highest or lowest close away from the median line over the given time frame of your choosing. The median line is based on simple linear regression based on closing prices.

Linear regression is an algebraic formula to help you find the median set of data over a given time and turn that median set into a line that can be extrapolated forward for trading. While that last sentence may have given you a headache, the regression line is drawn for you when you pick an appropriate high and low and a channel around the line will help provide you with a trading bias going forward.

Learn Forex: Regression Line Provides Directional Bias between two extremes

How Regression Channels Can Enhance Your Trend Trading

Chart Created by Tyler Yell, CMT

Once the regression channel is selected, you need to select the high and low over the current period for the regression channel to be drawn. You can see above that the channel is drawn off the most extreme close higher or lower away from the linear regression line. The channel does not have to be redrawn as the lines are set to extend forward.

Helpful Tip: when prices exceeds the upper or low channel line, you are either witnessing an extreme that is about to see a powerful bounce back toward the median line or a reversal that can provide many subsequent opportunities.

How to Trade Regression Channels

The main point of regression channels is to trade in the direction of the linear regression line. The EURUSD chart has the regression line pointing lower, which provides traders with a bearish bias. Because we always care about trading with a good risk: reward, when prices are above the regression line or pushing into the regression channel top line, sell trades can be taken with a stop above the recent high or a fixed pip amount depending on your preference.

Learn Forex: Regression Channel on USDOLLAR Shows Important Support

Chart Created by Tyler Yell, CMT

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Chart Created by Tyler Yell, CMT

It’s exciting to think about the top but the occurrence is rare and therefore, it’s often best to bet on trend continuation. Of course, with the appropriate amount of leverage a break of support doesn’t hurt as bad and can keep your mind at ease when volatility rises.

Recommended Reading: When Markets are Nervous, You Don’t Have To Be

When deciding when to take profit, the most common approach is with the regression line. The more aggressive traders can look to the top line and trail their stops on a move to the regression channel top but the top line in an uptrend is rarely touched / overshot except in the strongest trends or exhaustion tops.

Learn Forex: Channels within Channel Can Help To Time Entries Within Larger Trends

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Chart Created by Tyler Yell, CMT

Lastly, if you like the concept of regression channel trading but want more action you can draw channels within channels. By drawing channels within channels, you can see when small corrections within the overall trend have expired and the overall trend and minor trend are now moving in the same direction. Either way, you can put a stop below the recent swing low or high for a downtrend once you see a closing break out of the corrective channel.

Happy Trading!

---Written by Tyler Yell, Trading Instructor

To contact Tyler, email tyell@dailyfx.com

Tyler is available on Twitter @ForexYell

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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