The Right Way to Use Lines in Trading (Part 5)
04/17/2009 12:01 am EST
I have been working with lines as my main trading tool for more than 38 years now. Lines are simple, lines capture the probable path of price well, and lines work over and over and over. My favorite lines are the three parallel lines that make up Median Lines, but I work with all sorts of lines in my trading.
Now let's look at what some consider to be the computer-enhanced version of Median Lines: Linear regression lines.
Roger Babson began working with moving averages in the very early 1900's, putting parallel channels above and below them when trying to determine the length and depth of an upcoming expansion or decline in the economic cycle. You can see these same techniques used today in Stoller (STARC) bands, Bollinger bands, Keltner bands, and many other variations, but call them what you will, they are all built on one principle: Revision to the mean. In older times, it was often said “As above, so below,” and that is basically the idea behind the various types of bands and channels.
When computers came upon the trading scene, raw computing power was unleashed on all the trading ideas and techniques of the past. Many of them were simply tweaked and others were “improved” by the power of the computer. Linear regression channels supposedly fall in this second category. In many ways, they function like self-adjusting Median Lines or parallel line channels. Their “self adjustment” is their strength, but also their weakness.
I was able to find quite a few profitable trades using linear regression channels. I applied the entry and exit methods on the linear regression channels that I use in my normal trading. I always use solid money management and a high risk-reward ratio when I trade. If you look carefully, you'll see I even used an inside sliding parallel for my second trade entry, and this is one of my favorite Median Line trade entry set ups.
You must know the “learning period” of the linear regression lines before you can judge their effectiveness, so for each set, the learning period begins at the start of the lines and ends at a small vertical line placed on each of the center or middle linear regression lines. The linear regression lines are then projected forward and you can look for potential trade entry set ups after each “learning period.”
Looking at the success I had in finding nice trades using linear regression lines, you might wonder if they have a weakness! I mentioned it earlier: Linear regression lines “self correct,” so they are very curve-fit. They are not a true leading indicator. Instead, they project forward the current mean, and you base your trades on the idea that price will return to the mean (in this case, the mean or its upper or lower parallel line).
Linear regression lines are powerful tools and can give you some wonderful trading opportunities if you combine them with quality trade entry set ups, solid money management, and keep your risk-reward ratio high enough. Please remember that they are constantly curve fitting themselves to price action, so unless you are careful, they will generate too many signals and you will constantly be “washed and rinsed” out of your positions.
Now let me show you why I favor Median Lines as my “lines of choice” when trading:
This is the same market, during the next five weeks of price action. From three alternating pivots, chosen by changes in behavior by price, I drew a simple Median Line and its parallels. Once drawn, you can see the lower Median Line parallel gave you three tremendous opportunities to get long, with low-risk stop loss orders. Price never came down to test your stop loss orders, it simply moved forward in relatively calm trading until price got near the Median Line and then exploded higher! These lines even gave me the near-perfect profit target at the upper Median Line parallel. In my trading experience, there is no better leading indicator than a good set of Median Lines.
The various line tools are all quite good if you learn how to use them and couple them with solid trading practices. Don't feel you have to limit yourself to one or the other, because they each have their strengths and weaknesses, so try one or try them all and find the ones you like. Then if you add good entry and exit set ups, quality money management practices, and watch your risk-reward ratio, you'll soon be on your way to consistent profits.
I wish you all good trading.