New Trading Systems and Methods, Fourth Edition

CHAPTER 6

Regression Analysis

Regression analysis is a way of measuring the relationship between two or more sets of data. A stock analyst might want to know the relationship between the price of gold per ounce and the share price of Barrick Gold Corporation (ABX). An economist might want to know how the more complex relationship between interest rates, inflation, and the trade balance changes the value of the U.S. dollar. A hedger or arbitrageur could use the relationship to establish the relative fair value of two related products, such as palm oil and soybean oil, in order to select the cheaper product or to profit from price distortions; or, an investor you might simply want to find the strongest stock in the banking sector. Regression analysis involves statistical measurements to determine the type of relationship that exists between the data studied. Many of the concepts are important in technical analysis and should be understood by all technicians, even if they are not used frequently. The techniques may also be directly used to trade, as is shown at the end of this chapter.

COMPONENTS OF A TIME SERIES

Regression analysis is often applied separately to the basic components of a time series. These basic components are the trend, seasonal (or secular trend), and cyclic elements. These three factors are present in all price data. The part of the data that cannot be explained by these three elements is considered random, or unaccountable price movement.

Trends are the basis ...