Linear Regression is a statistical tool used to get an idea about the fair value of an instrument. It is basically a straight line drawn in such a way that the space between the line and the price points stand at a minimum and the line is the best fit. The line shows the trend in a very simple way and whenever the price stretches away too much from the line, the traders expect a mean reversion to take place soon. To define the overstretching in a more objective manner, the furthest distance of a price high or price low is taken and two lines, both parallel to the Linear Regression Line, are drawn. It is called the Raff Regression Channel.
Advantages And Limitations of Linear Regression
The Linear Regression line shows the underlying trend very well and the application of channel shows the extensions but this tool alone can’t be used for trading signals. If the price is seen testing the upper boundary of the channel and a Negative Divergence is seen on RSI too, that can be taken as an initial signal of a possible trend reversal. On the other hand, when it comes to the channel, the boundaries can project an abnormal range if the furthest distance emerges from a spike high or spike low.