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Standard Error Channel
Description
Standard Error Channels are calculated by plotting two parallel
lines above and below an x-period linear regression trendline. The
lines are plotted a specified number of standard errors away from
the linear regression trendline.
For information on other channel-based line studies, see
Envelopes,
Raff Regression Channels, Standard
Deviation Channels, and Standard Error
Bands.
Interpretation
Price movements are characterized by swings from one extreme
to the other. Markets reflect the collective mood if its
participants. When market participants are overly optimistic, prices
are driven up at an unsustainable rate. Likewise, when market
participants are overly pessimistic, prices are beaten down at an
unsustainable rate. The keywords here are "extreme" and
"unsustainable." Even the most raging bull markets or violent bear
markets will either pause for a breather or reverse temporarily.
Markets tend to have an equilibrium point (i.e., a point towards
which prices tend to be drawn). Linear regression analysis is
helpful in determining where this "balancing point" lies. On the
other hand, standard error analysis is helpful in determining where
the "extremes" lie.
Standard Error Channels can be used to enhance several types of
technical analysis techniques. Here are some ideas:
- Validate candlestick patterns: Enter long on bullish
engulfing lines only if they have formed below the bottom
channel line.
- Validate overbought/oversold signals: Close long (or
enter short) when the Stochastic falls below 80, volume is above
average, and prices have recently fallen below the top channel
line.
- Validate support/resistance breakouts: If prices have
broken above a long-term resistance level, yet volume is
suspiciously light, wait until the prices break above the upper
channel on above average volume.
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