Since mid-September 2009, the rally in QQQQ, the Nasdaq-100® Index exchange traded fund [ETF], has pushed the security into the regression channel that formed most of the 2003-2007 rally. This article looks at some characteristics of linear regression channels I’ve had in place since 2006 and things you may want to consider when using the channels for analysis or trading. The information identifies how I use the channels versus formal definitions from technical analysis.
In my experience, channel construction follows a similar path as trendline construction. You can start with a couple of price highs or lows to create a potential channel, but you need to remain flexible until the channel is confirmed. With trendline construction this entails a third successful touch of the line. Rather than a third touch of an extreme boundary, a channel becomes more reliable to me when price remains within the upper and lower channel lines as the trend continues.
At times it may be necessary to re-assess the channel as new pricing information becomes available; however, it cannot be re-drawn in attempt to see what you want to see. The longer a linear regression channels is in place, the stronger it is deemed. This means I have to have a very compelling reason for re-drawing a channel that has been in place for a longer period of time. The time interval can be measured by the amount of data conforming to the channel (i.e. number of daily closes) or the period shown on the chart (i.e. weekly versus daily closes).
New channels may be drawn in the same direction when price accelerates in the same direction or when it decelerates – this can be seen after a major reversal as price volatility subsides and gets into a more sustainable trend. The need to be flexible when constructing channels can certainly introduce bias into an assessment, but it does seem that there is more objectivity when using channels then simple trendlines. The fact that the center line is a statistical measure certainly helps the case. Regardless, it’s important to keep in mind the potential subjectivity when trading channels.
Basic Channel Application
Since a channel is constructed using a regression line at the center, the expectation is for price to continue to move in such a way that an extended regression line will continue to be the line of best fit for the data. In other words, price will move about that line providing the trend is in place. When it progresses too far above or below that line, you expect to revert back to the mean by returning to the line. Basically, “too far” is defined by a price move approaching the upper or lower channel line.
It’s expected that price will move from the middle line to the upper or lower channel line, then back to the regression line. It may return to the same boundary or travel to the other boundary line, but eventually returns to the regression line when the trend is intact. When price moves outside of an established channel, it alerts the trader to a change in trend. This may include price acceleration or deceleration in the same direction (both seen in Figure 1), or a reversal.
Price is monitored as it approaches different channel lines to assess the likelihood that line will serve as support/resistance. Momentum and volume tools can be used for this, along with other traditional tools such as moving averages which may provide additional support/resistance for price. In order for a movement out of the channel to be sustained, relatively strong momentum and volume should accompany it.
Figure 1: QQQQ Weekly Chart with Two Linear Regression Channels
Since I didn’t start using channels later, I constructed the second channel (10/31/03 – 10/27/06) as my starting point, but it would have been reasonable for a trader to construct the first channel (1/23/04 – 12/30/05) much sooner. Note both channels reflect a more sustainable trend than the initial reversal seen as an uptrend in the first part of the chart (no channel drawn).
The acceleration out of the channel(s) in the spring/summer 2007 occurred with an RSI divergence at the price high. More notable, when price returned to the channel, RSI broke below 50 – an area that had served as support in the uptrend. More importantly, it also broke below 40 into a bearish RSI range (see "Analytical Toolbox" articles from July 2008 on Cardwell Techniques, including bullish/bearish ranges).
I generally use the Relative Strength Index [RSI] for momentum, On Balance Volume [OBV] for volume, and the 50-day & 200-day exponential moving averages [EMAs] with channel analysis. The Moving Average Convergence Divergence [MACD] indicator may be added since it has both leading and lagging characteristics (moving averages plus rate of change).
To see a more thorough analysis of these tools used together, search “Market Outlook” in the article archives. There are a few real-time examples provided in the Analytical Toolbox series from 2007 and 2008.
Tips
Extend the channels to the left as well as to the right to see if it previously served as a valid channel. It may help you select a channel you deem is best (Figure 3).
Be sure to include in your analysis a chart view that excludes any channels so all of the trending lines don’t skew your perspective. I use compressed, weekly line charts to keep the actual trend more clearly in view and to minimize price noise (Figure 2).
Consider maintaining older channels in lighter colors and/or thinner lines to minimize distractions on the chart. Keeping them on the chart helps identify additional areas of support or resistance that may be looming (see Figure 4).
Figure 2: QQQQ Weekly Compressed Chart
Trend accelerated downward from the initial channel drawn in the fall of 2008 to the shorter term downward channel in red. It is this original channel that may be providing some resistance for QQQQ now.
Figure 3: Weekly Chart from 2008
Note the bullish move in both RSI and MACD momentum after the double-bottom in QQQQ this past March. I deemed the move suspect until it was able to move completely out of the red channel – and even then had my doubts. I then focused on the original downward trending channel (grey), but eventually added an upward trending channel to track the recent rally.
Current Conditions for QQQQ
Since the decline in QQQQ was relatively smaller than the S&P 500® Index given its exposure to financial names, the Mar-Oct rally actually pushed the ETF back into the long-term bullish channel. Figures 3 and 4 provide a current weekly and daily view, respectively. The former includes quite a few channel lines, some of which can be deleted when performing an analysis of current conditions. Just don’t save the deletions to keep older or inactive channels in view.
The original upward trending channel drawn on the chart that follows did not include the July low resulting in a more narrow lower channel. Since it included a relatively short period of time, the channel was re-drawn to allow for the price retracement.
Figure 4: Weekly Chart with Multiple Channel Lines
The recent rally appears to have met with significant resistance from the upper regression channel line constructed in 2008 (red) and extended forward. It is now accompanied by resistance from the middle line of the current, upward trending channel (green). Important information to note when Friday’s closing data is available includes:
- Price relative to the channel lines for the recent upward channel and the older downward channel.
- Price relative to the 10-week EMA (corresponds to the 50-day EMA)
- RSI confirmation (downward with price) and whether the 60 level serves as support. If the latter occurs, conditions favor the current channel holding.
- A MACD bearish cross. The setting for this indicator is slightly slower than RSI and helps prevent me from jumping the gun when there is one close outside a channel.
OBV has been excluded since it is a cumulative index that can be misleading when all of the data for the week is not available (add on Friday and look for confirmation/divergence).
Figure 5: Daily Chart with Cleaner View
The daily chart shows that today’s close was below the 50-day EMA. RSI is approximately at 40 and OBV is approaching a valid upward trendline. In the event QQQQ rebounds towards the end of the week with RSI supported by the 40 level, the trend is deemed intact. A break of 40 makes the rebound more suspect. Similarly, if the OBV trendline holds on a rebound, conditions favor a renewed attempt at the upper channel line (red). Momentum and volume should then confirm price if a sustained move above the red channel is favored.
In the event price continues downward with a break of the RSI 40 level and OBV support, a move to the lower channel line (green) is favored. Any failed attempts to break back through the 40 level for suggest a longer term downward move for price. Continued downward movement should then be met with stronger support at the middle regression channel line (red) which may, at that point, coincide with the 200-day EMA.
Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
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