The Linear Regression tool not only draws a trend line for you, it also draws a channel for that trend.
The tool is made up of three components:
- Regression Line - drawn by user based on first two waves of a trend reversal
- Standard Deviation channel - drawn by LR tool; default set to two standard deviations
- % Channel - adjusted by user after drawing the Regression Line
My settings are shown here:
First select the tool, then trace a line from the start of a trend reversal to the end of the next wave. The following example shows a long reversal. The line is drawn from the lower low to the next higher low. In Elliot Wave terminology, that is from the beginning of Wave 1 to the end of Wave 2. Don't worry about placing the line vertically on the chart; the LR tool will do that for you. It is important only that you START the line at the bar where the reversal occurred, and END the line at the bar where the next higher low occurred.
The portion of the line that is drawn is represented by the solid line; the dotted line represents the "prediction" of the trend based on that first Wave.
The solid blue lines represent two standard deviations from the Regression Line, and form the Regression Channel. Statistically, 96% of prices in the trend will be contained within the Regression Channel. That means that prices can venture outside of the channel, yet still remain in the trend. How then to capture those "extra" prices that deviate beyond the Regression Channel?
Regression Line and Channel
The % Channel is used to capture prices that deviate outside of the 2 STD Regression channel. This is adjusted manually by the trader. After first drawing the Regression Line and Regression Channel, open the Linear Regression Properties Window (shown above), check the box next to "Percent Channel" then change the % of the Percent Channel until the dotted line matches the first major swing high and/or low of the new trend, as shown below.
Regression Line and Channel with % Channel
Note how the % Channel manages to hold the prices at point (a); although they exceeded the two standard deviations channel, they are still "in the trend" because they are held within the % channel and they follow the slope of the original Regression Line. Note also how prices follow the original Standard Deviations Channel at (b). Even after breaking out of the % Channel at (c), prices follow the outer % Channel up as resistance before continuing sideways - a lateral or "congestion" breakout.
In many cases, the Regression Channel has obvious advantages over the Parallel Lines tool, which is another means of drawing trend lines. The same price action is shown below, using the Parallel Lines tool:
