Hello friends, I'm happy to roll into this week's SCA home work. Below is my comprehension of the lecture given by Professor @kouba01, thanks for patiently going through.
- Discuss your understanding of the principle of linear regression and its use as a trading indicator and show how it is calculated?
Linear regression tries to investigate the correlation that exists among regressand (dependent variable) and regressors (explanatory variables) and this relationship could either be between price and a particular asset(s) or possibly relationship in any variable at all.
Nevertheless,this can be observed in a diagramatic straight line where all points on a line try to cluster within it either in a positive or in a negative slope.
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In reality, the Ordinary Least Square (OLS) or the Classical Least Square is one of the simple statistical or econometric methods that investigates the relationship of different statistical observations with fairly satisfactory results and this can be applied in linear regression
For instance, we know that there are many contingencies to the determinant of the price and quantity of a commodity that could be supplied and hence linear regression will have it mathematically viz.
Y= f(X)
Here we are trying to state that qty Y to be supplied of an asset of the price of an asset is determined by many unknowns which is (X)
But statistically, it can be stated that Yi = b0 + b1 Xi
Also in this instance, we assume that the quantity or price of the dependent variable (Yi) is determined by the constant variable b0 and the slope of other independent variables but in this case, there is only one regressor (Xi) with its unestimated parameter b1.
Finally linear regression tries to investigate the relationship that exists between the quantity or price of this commodity (Yi) and the other variable (Xi) with regards to its obtainable statistical estimates.
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On the other hand, The linear indicator like the Moving Average is used in determining the possible trend of an asset while maintaining the lag or regression potency of any asset in question. Though it works like the MA, it responds quicker to trend movements and directions than the MA itself.
Hence, the Linear regression tool as a trend following Indicator tries to follow the price chart and to this end we believe that there are many factors that affect price and these could be observed when carrying out a technical or fundamental analysis and this indicator isn't recalcitrant to these factors as it follows the chart trend and does not vary at levels of levels of price movement.
Using this indicator, a trader can go for a buy long option once it turns up and contrarily, he can go for a short sale once the indicator turns downwards.
This indicator uses a normal statistical regression formula and this can be stated thus.
Y = a + bX
Where
Y= regressand or dependent variable
a= constant or intercept
bX= parameter slope or the unknown independent variable.
However, a + bXi are lag variables and using their coefficients, you can determine the Y estimate or value.
But statistically the following can be determined.
With respect to "A. Koutsoyiannis" on (Theory of Econometrics 11)
n= Time variable and going by the default setting of this indicator is 14 periods
X= this is the explanatory variable and it shows more of what happens to the regressand
Y= This is the variable or asset that is being investigated and can also be referred to as the dependent variable.
B0 = constant or intercept
B1 = slope of the regression line
2 Show how to add the indicator to the graph, How to configure the linear regression indicator and is it advisable to change its default settings? (Screenshot required)
To be able to add this indicator to any chart, the chart has to be inserted first before this Indicator could be added to it. Nevertheless I will be using the STEEM/USDT graphical chart on trading view to add this Indicator.
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After choosing the STEEM/USDT chart on the trading view using Huobi Exchange, next is to click on the indicator icon at the top corner of the trading view interface.
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On the search box is to type "regression" and select the regression line formula.
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the Indicator will automatically insert into the trading chart after clicking enter key.
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There are three basic modification levels in this indicator, which are as follows: Input, style, visibility.
Now to modify this Indicator, you click on the setting icon at the upper left corner where the indicator name is displayed.
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The initial settings modification is the input which has a default value of 14 periods that is a two weeks interval, so a trader can either change it to suit his trade, still based on his trading behavior after which you click ok.
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Next is the style setting which is all about the line modification, and here one can change the color and size based on his choice after which you hit the ok box
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The last on the setting box is the visibility area, which has a range of time that runs from one seconds to 12 months. I don't think anything needs to be reset here as time is a global parameter that cannot be changed but finally after viewing the time, you click ok. This is actually how to configure this indicator.
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3 How does this indicator allow us to highlight the direction of a trend and identify any signs of a change in the trend itself? (Screenshot required)
The linear regression indicator can be used in identifying possible trend directions either in the Bull or in the Bear and also subsequent changes from either the Bull to the Bear and vice versa can still be spotted using the indicator.
Finally, I believe that the default settings of this indicator came out of a well fashioned hypothesis and accurate findings and this can be changed based on the technical know-how of any trader but it is also advisable for a trader to use its default settings if the trader has not actually mastered the Indicator to certain credible height and since everything is geared against trade losses, I believe that the default setting of this Indicator can also assist in proper management of risk without further modification that can lead to malfunctioning of the Indicator itself.
Like most indicators, the linear indicator can identify trends in the bull direction and this is spotted as the linear Indicator shows a strong upwards direction probably after a bear trend or after price consolidation at the lower side of the market.
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Using the Steem/USDT chart above we can see the upwards movement of the LRI which is also a confirmation of the Bull trend as indicated in the price chart.
The LRI also identifies trends in the bear direction and this is simply by a downward movement of the Indicator probably after a Bull trend.
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Also using the Steem/USDT chart above we can see the Bear trend taken by the price chart as the Indicator makes a strong downtrend.
During trend reversals, this indicator starts creating weaker trends instead of a strong up or down trend to confirm a reversal and this could be confirmed in the Bear or in the Bull trend and more so, this is backed with the concept that every Bull trend has a consequent Bear trend and vice versa.
In a Bull reversal, the LRI must have been creating weaker trends in a bear direction or probably in a price consolidation at the low level of the bear trend and subsequently taking an opposite direction from the previous Bear trend.
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Using the Luna/USDT price chart above, we can see the weakness created by the bear trend line which also corresponds to the weakness in the LRI before the Bull reversal.
In a Bear reversal, the LRI must have been in a Bull trend and hence start making trend weakness and possibly create price consolidation in the upper side of the market , before taking the opposite direction to the Bear to confirm a true Bear reversal.
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Using the Luna/USDT chart above, we can confirm the Bear reversal after the period of weakness observed in the LRI and then a double top or price consolidation at the Bull side of the market before plunging to the Bear.
4 Based on the use of price crossing strategy with the indicator, how can one predict whether the trend will be bullish or bearish (screenshot required)
In this regard, the LRI can be used in predicting bullish or bearish trends at intervals of price chart intercepting with the indicator and as such, if the intersection was met above an average position in the price chart, the trend plunges into a downtrend which could either last of a long or short period and on the contrary, if the point of intersection is below an average position in the candle chart, the subsequent trend will be an uptrend which may also last for a longer or shorter period and these are the same for both Bull and Bear trends.
Using the chart below, we will be looking into how these scenarios occur at different market phases
If the crossing that occurs in a bull trend intersects the candle chart below its average height, it results in a continuous Bull trend but if it crosses it from above average, it plunges it into a down trend which could either be a short or a long trend.
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Using the Luna/USDT chart above, we can confirm that whenever the Indicator crosses the price chart below its average, it creates a further bull and when it intersects from above, it creates a short bear trend.
In a bear trend for instance, this indicator tries to create a more downtrend when it crosses the price chart above average and on the other hand, there is a little up swing in the price chart when the Indicator crosses it below average.
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Also using the LUNA/USDT chart above, we can confirm that while the Indicator crosses the price chart above it's average, that a continuous downtrend kept on till the resistance point.
5 Explain how the moving average indicator helps strengthen the signals determined by the linear regression indicator. (screenshot required)
In reality, we believe that there is no absolutely sole used indicator that does not create a kind of doubt in the mind of a trader while in trade and the same applies to the LRI.
Nevertheless, the amalgamation of the MA in trend reinforcement signals has gone a long way in helping a trader in keeping faith in these two indicators.
We know that both the LRI and the MA are trend following indicators and as such, they do not create trend divergence unless when not properly set.
Now since both Indicators try to follow trends and also give trend signals, the crossing of both Indicators either in a Bull trend or in a Bear trend has significant impact in the reinforcement of price trends.
Finally, we will be seeing this on both sides of the price chart that is in the Bull and in the Bear trend.
During a bull trend, the combination of these indicators creates a very significant effect to maintain the Bull confirmation. Nevertheless, to confirm this, the LRI has to cross the MA from below to the top and once this is confirmed, there is a definite bull trend till it hits a resistance point or till there is a weakening in the current trend
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Using the LUNA/USDT chart above, we can see that as the LRI crosses the MA from the bottom to the top, there was a strong Bull reinforcement in the trend.
For trend reinforcement in a bear trend, the LRI had to cross the MA from the top to the bottom side and once this is confirmed, it gives a trader the Impetus to go for a short sale or possibly exit the market against trade loss.
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Using the LUNA/USDT chart above, we can confirm that as the LRI crossed the MA from the top, it plunged the current trend into a serious downtrend to confirm the reinforcement in these indicators.
6 Do you see the effectiveness of using the linear regression indicator in the style of CFD trading? Show the main differences between this indicator and the TSF indicator (screenshot required)
While trading CFD, traders normally go for a short term trade to reap profit on time and exit the market.
On the other hand, there is no trader that can reap credible profit without the use of good indicators of which this indicator can help in generating good returns if properly managed because of its quick response to market volatility.
Nevertheless, since this indicator normally follows price trends simultaneously, it truly has a great effect in assisting CFD traders in making great profits as they can enter for a buy trade once the Indicator points up and they can also go for a sale trade if the Indicator points downwards depending on the current market condition as a CFD trader can go for a buy long if the upwards sloping is after a bear market or price consolidation at the lower side or possibly after a price has hit a support level.
On the other hand, CFD traders can also go for a sell position, if the downward slope of the Indicator is after price consolidation at the upper side of the market or probably after the price chart has hit a resistance point or even after a Bull trend.
The Difference Between The LRI and The Time Series Formula
The main difference between the both indicators is that the LRI gives a quicker response to price volatility than the Time Series Formula although both of them use the lag values of the price chart in determining market prices, but the LRI adapts to the current fluctuation in market prices than the TSF as the TSF shows a more smooth movement than the LRI although this can vary if the settings are reduced to fit a shorter trading period.
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Using this Luna/USDT chart above, we may not observe it very properly but if placed in motion, a closer watch indicates that there is a quicker response to the price chart than the TSF indicator. That is there is more volatile movement in the LRI than the TSF.
7 List the advantages and disadvantages of the linear regression indicator:
- The LRI is a good time adapter that responds quicker to the current market.
- It is simple to use as an uptrend can be confirmed as the LRI points upwards
It does not create divergences as it accurately follows the price trend.
A combination of some other indicators that can work linearly with the LRI like the MA will help a trader in either market entry or exit as the crossing of both Indicators has a significant effect on price variation.
The calculation of this indicator can assist for statistical purposes.
- The calculation of the LRI does not have any significant effect in the determinant of future market price since it makes use of lag variables.
- Due to the high level of responsiveness of this indicator to price movement, it might give a false signal which when followed may lead to trade loss.
- This indicator may not adapt to a very high price volatility and such, if used during this period, may not produce the real or expected trend signal.
The LRI has a good potential in predicting possible trend signals that can assist traders in making good profit from trades.
Although this Indicator works perfectly on its own, a combination of some other indicators to it will produce a more perfect trend signal like the addition of the MW into it.
Finally, In my use of Indicators, I believe that my knowledge of this indicator has added to my trading tools which will also help me in managing my trading risk properly, thanks Prof.
Cc: @kouba01