Constructing a least-squares trend channel with two-standard-deviation rails

Fit the midline and the rails

A statistically positioned trend channel is constructed by fitting a least-squares straight line through highs, lows, and closes from a chosen early turning bar to a recent bar, then drawing parallels two standard deviations above and below that line.

The least-squares midline is the single straight line that minimizes squared distances to the highs, lows, and closes inside that chosen bar window.

The scatter used to place the parallels is the standard deviation of the distances from the fitted line to the highs, lows, and closes inside the selected window. The two-standard-deviation rails are a pair of lines parallel to the midline and offset by twice that standard deviation, used as the channel's outer edges.

If those distances are treated as approximately normal, about 95 percent of the window's high, low, and close observations are expected to lie between the minus-two and plus-two standard-deviation rails.

A maturity check before support and resistance

Because nearly all observations in the window are expected inside the envelope, the outer rails are used as candidate support and resistance levels, subject to a separate maturity check.

A projected turning level from a channel edge is not treated as mature until the sides have been contacted at least three times. A channel contact is an occasion when price reaches or slightly crosses a rail. The leftmost bar of the channel is ordinarily counted as the first contact.

Nested channels and intersections

Smaller channels can be drawn inside larger ones. A nested channel is a statistically positioned envelope drawn on a shorter window that sits inside a larger envelope on a longer window. Their intersections are treated as candidate turning locations even when a nested envelope has only two edge contacts.

Match the price scale to the move

When prices have moved through a wide range, the regression and deviation calculations are to be performed on logarithms of price. Semilog construction fits the midline and rails to the logarithms of price so equal percentage moves occupy equal vertical space.

Scale mismatch is the use of a linear price axis on a fast-moving series, which can place the same observations outside rails that would contain them on a logarithmic axis. On a linear scale the same series can travel well beyond an otherwise comparable envelope.

Construct a reversal warning

An early reversal warning is constructed when an established advance fails to reach the upper rail. Confirmation is constructed when price later crosses the lower rail.

The same construction is described as applicable to any chartable bar length from one-minute bars to yearly bars, and to declining as well as advancing trends.