Analytical Toolbox: Extending Regression Channels
September 10, 2009
Price channels can be constructed in a variety of ways, providing option traders with different profit opportunities depending upon the strategies used. In order to effectively select a strategy, the trader needs to understand channel construction. This article focuses on different channels available in ProfitSource; check the Platinum Toolbox article, Channel Tools from September 3rd, for a primer on channel construction in Optionetics Platinum Pro.
There are five different types of price channels available in ProfitSource. Four of the five channels are constructed by creating a regression line for price data using user-defined start and end dates. The fifth, a Price Percentage Channel, uses a trader drawn line (similar to a trendline) and creates upper and low lines based on a user-defined percentage of the first trading bar price. Since there are many more variations that can be created from such a construction, this channel type is not covered here.
The remaining four channels include:
- Linear Regression Channel
- Raff Regression Channel
- Regression Percentage Channel
- Standard Deviation Channel
Since the construction for all of these starts with a regression line, it makes sense to break that down first. A regression line is also referred to as a line of best fit; it’s the line that results in the smallest value when you add up the distance from each data point to that line. Figure 1 provides a quick visual on the distances referred to for this smallest value. You can tell the data is a bit old when you view VIX levels on the bottom scale.
Figure 1: Line of Best Fit Distances
The data points generally represent closing values for the period, but ProfitSource does have nice flexibility here allowing you to use the high, low, open or close for the center line construction.
What exactly is a regression line telling you on a price chart? First, it’s a nice objective way to identify the trend over a specific period. An upward sloping line tells you an upward trend was in place for the interval and a downward sloping line tells you it was a downtrend. That may be super obvious without the line, but it’s always good to have those unbiased tools at your disposal.
More importantly, from a statistical point of view, the line can be extended to the right so a trader can view where future prices are expected to fall. Rather than new data points (prices) falling right on the line you’ll have some above and below it, but the line of best attribute should still apply. This provides trading guidance because once you have prices moving a little too far from that line, you can anticipate a return back to, and possibly past it. The regression line can serve as a baseline for a reversion to the mean approach.
Since the markets don’t behave in a nice orderly statistical manner, there’s no guarantee that prices will move around a projected regression line, but such trends can persist. Figure 2 displays a linear regression channel constructed from a regression line using 1-1/2 years of weekly closes. Once prices became a little over-extended, they returned to the center line for another 1-1/2 years before they had enough bullish strength to accelerate further upward. The January 22nd & 29th Analytical Toolbox articles provide additional information on constructing and trading linear regression channels for those who are interested.
Figure 2: Regression Channel Constructed with 18 Months of Data
So what let’s you know when price is traveling a little too far from the line? That’s where the upper and lower channel lines come in. These additional lines provide you with expected movement away from the regression trend line, given past movement for the same period. Beyond these limits, it’s possible a change in trend characteristics is emerging (accelerating or reversing).
Construction of the upper and lower channel line is where the four channel types listed differ. The channel(s) you decide to use is really a matter of personal preference. Just be sure you understand how the lines are set and what they are telling you. A brief description is included here, along with the last chart which provides all four channels using the default settings for each and the same start and end dates. The chart is a daily close bar chart for Genzyme (GENZ), which came up in a scan on last week’s Platinum Toolbox article.
Figure 3: Daily Chart for GENZ with Four Channels
Each of the channels drawn has a common center line. In addition, the Linear Regression Channel [LRC] and Raff Regression Channel [RRC] share the upper channel line. For that reason, the LRC is extended to the right and the RRC is extended to the left for clearer viewing.
Linear Regression Channel: Developed by Gilbert Raff, the upper and lower channel lines are drawn parallel to the center line using the data point within the time period that is the furthest away from the center line. Generally this means the two lines are different distances away from the center line. This construction then captures previous extreme movements in the trend.
Raff Regression Channel: Developed by Gilbert Raff, the upper or lower channel line is drawn parallel to the center line using the data point within the time period that is the furthest away from the center line. If the lower line is drawn first, the upper line is then drawn the same distance away from the center line (and vice versa). This construction then captures previous extreme movements in the trend, with some leeway on the line drawn second.
Regression Percentage Channel: The upper and lower channel lines are drawn a fixed percentage away from the center line, which is a user-defined value and on the start day’s price. The upper and lower channel lines can be set at the same percentage or different percentages, so the distance for each to the center line varies.
Standard Deviation Channel: The upper and lower channel lines are drawn a fixed number of standard deviations away from the center line, which is a user-defined value. The upper and lower channel lines can be set at the same number of standard deviations or different ones, so the distance for each to the center line varies.
While it may be nice to see the four channels together on one chart (or not), it’s probably most effective for you to just play around with them on ProfitSource. Think about the volatility that is being captured when you create the envelopes and project them forward for monitoring.
To access other articles written by Clare White, please click here.
Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
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