From the June 01, 2008 issue of Futures Magazine • Subscribe!

Reaping profits with regression analysis

If you trade corn, you know the top chart shown in “Light on their feet” quite well. The extent to which prices have moved during this six-month period has been historic in its scope. However, the lines on the chart might not be that familiar. They form a linear regression channel (LRC) bounding price by a sell line along the top, a mean along the center and a buy line along the bottom.

During mid-March 2008, corn broke off the mean, found support at the buy line and then returned (regressed) toward that mean. Now look at the euro chart shown below the corn chart. You may be surprised by the similarity between corn and the euro. During mid-March 2008, the euro broke off the sell line, found support at the mean and then rallied back up toward the sell line. Clearly, the corn-euro link and the LRCs provided some key information during this period, but these relationships don’t stop there.

Consider “Heavy handed,” which shows May wheat from October through March. The price action in wheat has been volatile, yet with all the volatility there was order. During March, wheat rallied off the mean to the sell line, broke off the sell line, punched through the mean, rallied to the mean then broke off the mean. In this case, we find similarity in gold. April gold futures are shown below the wheat chart. During March, gold rallied off the mean to the sell line, broke off the sell line, punched through the mean, rallied to the mean then faded, while gold matched wheat.

Now, mentally erase the LRCs from corn and wheat. Then, cover up the euro and gold charts. Order is no longer perceived on the charts. Price action appears to be more random. But with the tools in place, trends are clearer. This is the result of situational awareness.

MONEY FLOW

That situational awareness comes from the information regarding money flow provided by LRCs and intermarket analysis. These tools are based on a logical appreciation of price and market behavior. One premise of this logic is that price explores while money exaggerates. In command markets, prices are fixed. In free markets, prices test their limits. Another premise is that price is relative; A is relative to B. The price of one financial instrument is determined in relationship with another (or others). Yet another premise is that money seeks the best return; money will seek A or B, and it will flow in and out of those financial instruments in search of that return.

LRCs and intermarket analysis guide money flow. Traders who do not understand money flow get blindsided, whipsawed and generally outclassed by traders who do understand it. This is market reality.

Consider LRCs from the viewpoint of friction. Sellers will resist an upward move and buyers will resist a downward move. It is a feature of channels that price, in an up channel, tends to explore low then high. In other words, price tends to pull back before extending. In a down channel, price tends to explore high then low. In both cases, price eventually will move too far from the mean and regress back to it. This is friction at work. LRCs help visualize friction and, by doing so, can help you time a trading decision.

Intermarket analysis is best used as confirmation. The principle of confirmation is that if two related markets are moving in tandem, then the same movements playing out in both confirm the individual moves in each. This works both with markets that typically move together and with markets that typically move opposite.

LRCs and intermarket analysis can help a corn trader become a better corn trader and a wheat trader become a better wheat trader. These tools also can help a market-neutral trader shift his money to whichever market is currently presenting the best trade. Day, swing and trend traders alike can benefit with LRCs and intermarket analysis by using it to time their trades and choose the best vehicle (which market, A or B) for their position.

THE PLOT THICKENS

LRCs and intermarket analysis also are effective when applied to different time periods. Consider “Going up,” an intraday chart for corn over an 11-day period. The price bars are set at 180 minutes. The right-most day is March 28, 2008.

From March 14, on the left edge of the chart, to March 20, near the center, corn marked a series of lower highs and lower lows. This action is a bear stair: The price appears to descend a set of stairs. From March 24 to March 28, the lows and highs are generally higher. This is a bull stair: The price appears to climb a set of stairs. Price moved from a position above the mean to a position below the mean before moving back above it. The LRC guided the action.

Drilling down even further, we can study the same concepts on a one-day corn chart (see “Buyer’s rule”). The time period between the left edge and right edge of the chart is 9:30 a.m. to 1:15 p.m., regular trading hours for corn. The price moved along either side of the mean. It is a feature of one-day LRCs that price will tend to move along a 45-degree channel. The buy line, mean and sell line will tend to assume a 45-degree inclination or declination. An LRC will pace the price. This observation is another way to improve the timing of a trading decision.

Of course, for either time period, you would be well served not to restrict your analysis to the corn chart, but also those for the euro, wheat and gold.

MOMENTUM

While LRCs can be thought of in terms of friction, they also have elements of momentum. Friction occurs within a single trading day just as it occurs within other time periods. Single days, however, have a unique tendency of closing on or near their intraday high or low (see “Analyze this”).

Days where the price closed near an extreme reflect when buying or selling momentum prevailed. It is easier for a trader to make money when such momentum predominates. Traders who make a living at trading gang up on the day’s losing side. Dominant traders benefit by pushing (exaggerating) price into the close. Tomorrow’s dominant traders may push in the opposite direction. Trading is competition. LRCs and intermarket analysis help mark out the playing field.

DO IT YOURSELF

Despite the benefits of LRC analysis, it’s not a universal tool on charting services. That implies that most small, independent traders are not aware of LRCs, nor do they ask for this capability.

However, that does not mean that these tools are inaccessible. Linear regression is an analysis tool that many of us learned in a basic college statistics course. There’s ample information available online that describes this analysis method in great detail, and many articles in this magazine have explained how to apply regression analysis for both single and multiple independent variable sets (see, for example, “Statistic Analysis for Traders,” Futures, May 2006).

However, rolling your own indicator is always more complicated than applying a ready-made version in your current charting application. So, if your service does not offer LRC, ask for it.

Still, that is a significant hurdle. Expect LRCs to remain an orphan approach among the masses. That said, intermarket analysis does receive a considerable amount of attention, relatively speaking, and is a common tool among individual traders. The combination of these two tools — one common, one not so much — is too powerful a blend to be left uncovered. Seek it out; consider it for the markets you typically follow, practice it and you’ll likely find a profitable new approach to add to your trading arsenal.

Richard L. Muehlberg uses linear regression channels and intermarket analysis to day-trade his own account. He publishes a day-trading diary on his Web site www.DayTradingWithLinesInTheSky.com. E-mail him at richardmue@yahoo.com.

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