How to Draw a Linear Regression on a Trading Chart - dummies

How to Draw a Linear Regression on a Trading Chart

On a trading chart, you can draw a line (called the linear regression line) that goes through the center of the price series, rather than along its edges. Although you can’t technically draw a straight line through the center of each price bar, the linear regression line minimizes the distance from itself to each price close along the line.

You can’t draw an accurate linear regression without first performing a complex statistical calculation. Spreadsheet software (including Microsoft Excel) and all charting packages come with the linear regression already built in. Don’t shoot yourself in the foot trying to do the calculations yourself when you could just as easily be sipping a latté while a program does it for you.

Figuring out where to start and where to end a linear regression line is the first big obstacle in using the line in a practical way to help you make trading decisions.

  • Start: The simple answer is to start it at an obvious high or low, meaning that you need to look backward at the historical data on the chart to see where the current move began.

    This history check can be trickier than it sounds. You can get very different slopes, depending on how tightly you want the data to fit to the line. Seeing a welter of slopes covering up your chart can get very frustrating. Stick with it — pare back the surplus lines until you get one that looks the best to your eye.

  • End: Figuring out where you end a linear regression takes some practice with other indicators, such as a gap, a giant outside day, a moving average crossover, a change in momentum, or even a nontechnical development.

You may see charts by self-appointed gurus that show a linear regression and advice that prices are “mean reverting” and exhibit a “central tendency,” meaning that a big variation away from the linear regression line will automatically correct back to the linear regression. This is nonsense. No reputable trading system features the linear regression as a trading tool.