The linear regression line, previously discussed, is one of the more important lines that can be drawn on a forex trading chart. More strongly than a resistance or support line can do, a linear regression illustrates the direction of a trend, and can be extended into the reasonable future for a forecast. The steepness of the line’s slope gives an idea of the strength and sustainability of the trend, for if the line is too dramatic in its forecast, one instinctively knows it cannot last.

However, a linear regression does not give the basic information carried by a simple resistance or support line: it does not show the extent of that price action, how high or low the price can be expected to travel before turning and retracing itself. For that data, the linear regression must be extended outward via the standard error channel.

The term “standard error” refers to the statistical measurement of the possible error inherent within any estimate. One needn’t entirely understand the term prior to feeling comfortable using the tool, and perhaps the novice technical traders should simply recognise that two standard deviations will encompass 95% of the price action about a linear regression, and it is this size channel that most charting software packages will automatically draw upon demand.

Obviously, a standard error channel will not enclose all of the price action on a forex chart. By definition, extreme highs and lows will rise above or fall beneath the channel’s boundaries.

It’s always important to remember that the graph of a currency pair’s movement is a direct reflection of the forex market’s group psychology at that given moment. The overenthusiastic bulls force the price up, the overpessimistic bears force it down, and the bars on the chart swing from one extreme to the other. These extremes, of course, are not sustainable, so when the price bars begin climbing out of a standard error channel, particularly if volume is suspiciously low, the savvy forex trader knows to watch for a change in trend, a sudden surge in volume, or a moderation of the price action to return it to the channel.

Examine the chart below. This is the four-hour chart for NZD/USD, dating from mid-April:

On the far right-hand side of the chart, note that the heikin ashi bars are spiking through the top of the standard error channel. Volume, as judged from the green bars at the bottom of the chart, is fairly average, and the three moving average lines—green, blue, and yellow—indicate the current trend remains strong. How, then, should this chart be interpreted?

The preponderance of the evidence does not give a buy signal here. The linear regression defines the trend as bearish, the volume is falling off and not supporting any change in trend, and the second spike through the channel boundary is marginally lower than the previous one. Remembering that a crossover of MA lines is a lagging indicator, often by five or more time period bars, one could be forgiven for refusing to buy on such a slender indication.

The decision was correct. Not even a doji gave warning of the sudden swing down in price, only the boundary of the standard error channel—the forex trader’s Distant Early Warning line of change.