Technical and quantitative analysts have applied statistical principles to the financial market since its inception. Some attempts have been very successful, while others have been anything but. The key is to find a way to identify price trends without the fallibility and bias of the human mind. One approach that can be successful for investors and is available in most charting tools is linear regression.
In this analysis, linear regression uses a weighted combination of the 50-, 100– and 200-day linear regression to present a scoring methodology.
This analysis would allow you to see when a share is overbought (expensive or higher scorer) or oversold (cheap or lower score) and ready to revert to the mean.
Please review the theory behind linear regression channel below.
How to Interpret the Linear Regression Channel pattern:
This multi-year chart of the S&P 500 exchange-traded fund (SPY) shows prices in a steady uptrend and maintaining in a tight one standard deviation linear regression channel.
Please note, this is an example trade – not a recommendation.
The upper and lower channel lines contain between themselves either 68% of all prices (if 1 standard deviation is used) or 95% of all prices (if 2 standard deviations are used).
When prices break outside of the channels, either: Buy or sell opportunities are present. Or the prior trend could be ending.
Possible Buy Signal
When the price falls below the lower channel line, and a trader expects a continuation of the trend, then a trader might consider it as a buy signal.
Possible Sell Signal
An opportunity for selling might occur when prices break above the upper channel line, but a continuation of the trend is expected by the trader. Other confirmation signs like prices closing back inside the linear regression channel might be used to initiate potential buy or sell orders. Also, other technical indicators might be used to confirm.
When the price closes outside of the linear regression channel for long periods of time, this is often interpreted as an early signal that the past price trend may be breaking and a significant reversal might be near.