Linear Regression Channels

The linear regression channel, similar to the Bollinger Bands, is a technical analysis tool that can be used to trade the binary options market.  The linear regression channel is a statistical technical analysis tool that captures the recent ranges and creates a statistical boundary where prices are likely to trade over a specific period of time.

Linear regression is a statistical approach to determining (via modeling) the relationship between one or more variables, where the model depends linearly on the unknown parameters to be estimated from the data.   The conditional mean of the given values (say prices of a financial instrument) are a function of that particular instrument or another instrument.  In essence, one specific variable is dependent, to a degree, on another specific variable.  The degree of dependence is called the R (squared), which is denoted in a percent format.

The linear regression channel is a channel that is created using a specific amount of data points where a regression line is created using the R (squared).  Parallel lines are then drawn that are one or two standard deviations away from the mean line.  The channel incorporates a larger percentage of the recent range of prices and theoretically will be bound where most of the price action over a future period of time.  This is accomplished by increasing or decreasing the standard deviation.  The larger the standard deviation, the more price and potentially future prices will be incorporated into the bands.  The linear regression channel can be used as a mean reverting indicator, where the bands on each end are support and resistance for price action.  In the hourly chart of USD/JPY, the linear regression channel incorporates the majority of price actions during a 20 period range.

The linear regression channel can be used successfully to trade hit or miss options, range options, one-touch options or above or below options.  For above or below options, an investor can use the high end of the linear regression channel to buy below options, and the low end of the linear regression channel to purchase above options.  For range trading, the channel should be an excellent strategy.  Placing a trade, this pays off if price action trades in a range in the future should be statistically significant.  This strategy is based on the idea that the current range will continue to perpetuate in the future is not other news is added to the market.  A two standard deviation range will incorporate 95% of the current prices, which should act as a very strong guide for future trading.  For example, a range box can be placed in front of the price action with a length that is similar to the trend channel.

These strategies using the linear regression channels have a lot of statistical merit and should be tested using numerous financial instruments to find the binary option and instrument that match an investor’s risk profile.