Sometimes forex charts can look downright chaotic. Drawing some lines along recent highs and lows may help make some of the chaos, but other times it doesn’t seem to help at all.
If you find this happens to you a lot—you look at your forex charts and scatch your head—then a regression trend tool may help.
What is a Regression Tool?
A linear regression tool draws a “line of best fit” through all the data between two points in time. For example, if you select the linear regression tool on your chart and then pick a higher or low point and then extend the line to the current point in time, the tool will find the line of best fit using all the price data from then till now.
Here’s an example. I picked a major high in the USDJPY and then picked the most recent price bar. The red middle line is the line of best fit between those two points in time. I then added a standard deviation channel above and below the linear regression line. Most linear regression tools will have this function. These charts are created with TradingView’s Regression Trend.
I have also added some additional support and resistance lines (green) which may be important. The regression tool is just a tool. We can and should do other analysis as well.
The regression tool has highlighted a channel lower…this where MOST of the price action occurs.
Next, we can add in more regression channels for more insight. The daily chart above covers almost three years. There are smaller patterns also at work.
Use the regression tool from the October 2018 high to now. It will create another channel.
On a shorter-term frame, we can see the USDJPY is moving in a downward channel and is currently near the top of that channel….but we also can’t forget that there is room above based on the bigger channel.
The price has also been recently rising. We can draw a regression channel from the August 2019 low to the current price to see the recent upward trajectory.
Possibly, at this point, you feel more confused than when you started, but the regression tool can really help you see different possibilities.
- The bigger trend (regression line) says we are moving lower in a downward channel, but we recently bounced and are moving toward the top of the big channel.
- We are near the top of the descending medium-term channel, so a continued move higher would indicate a move toward the top of the big channel (breakout higher from the medium-term channel). If the price drops, the medium-term channel has held and provides a price trajectory to the downside.
- The small channel is pointing upwards and signals a potential rise toward the top of the big channel. If the price starts dropping below the small channel, then the pair could be headed back toward the bigger channel bottoms.
Things to Consider about Linear Regression Tools
This tool is not meant to make your trade decisions for you. As indicated at the beginning, it may help simplify the price data when it looks chaotic. It is quite possible you wouldn’t have seen these trend channels if you didn’t use the regression tool, because the tool is looking for “best fit” whereas most of us only tend to recognize chart patterns that perfectly line up (or close to it).
The regression trend tools show lines of best fit. They are not meant to capture extreme highs and lows. The regression tools help highlight where the currency pair has traded most of the time.
The actual regression line, the line in the middle of the channels, is the heart of all the price data between the two points. You can think of that line as the line that is touched the most often. That means it will often act as a good profit target. For example, if you buy near the bottom fo a channel you could sell near the middle of that channel.
The upper and lower channel limits are a certain number of standard deviations away from the regression line. In the charts above, the channels are the regression line +1.5 and -1.5 standard deviations. Adjust to make wider or smaller channels.
Without getting into a statistical talk, the more standard deviations away from the regression line the less likely the price is going to spend much time there. Therefore, while the upper and lower channels can be used as profit targets, the price likely won’t spend much time there. For this reason, I will often look for long entry signals near the bottom of a regression channel (especially if the channel is pointed up) or a short trade near the top of the channel (especially if the channel is pointed down).
Remember your time frame. The big three-year regression trend provides context, showing that there is some room to the upside if the USDJPY decides to continue higher. The smaller channels are more applicable to swing traders trades that last a few days to a few months.
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, or even more than you deposited if using leverage.