Reaping Profits with Regression Analysis
Muehlberg, Richard L., Modern Trader
Regression channels and intermarket analysis are excellent tools for providing situational awareness of the markets. Here's a demonstration of how effective they can be in the grain markets.
If you trade corn, you know the top chart shown in "Light on their feet" (right) 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" (far right), 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 com and wheat. Then, cover up the euro and gold charts. Order is no longer perceived on the charts. Price action appears to lie more random. But with the tools in place, trends are clearer. This is the result of situational awareness.
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. …