Stocks & Commodities V16:4 (173-179): Identifying Market Trends by Jack Karczewski

INDICATORS

Identifying Market Trends

The trend of the market is key to most every technical
approach available. But the market doesnt always trend.
Heres how to use a statistical tool for determining if the
market is in a trend.
by Jack Karczewski
raders spend untold amounts of
intellectual capital analyzing a
market for clues about trend. We
try to determine if there is a trend
present, when it began, if it has
reversed or broken down. The
methods employed to interpret
this information range from
simple chart analysis to sophisticated computer algorithms. Even
simple moving averages can become quite complex when the
permutations and combinations of moving averages, their
various lengths, crossovers and forms such as simple, weighted
and exponential, are considered.
I use one analytical method in particular to identify trends.
This technique gives not only the direction, but the slope, the
magnitude of the error of the prediction and the reliability of
the forecast of the trend. The statistical method is referred to
as linear regression. This tool has become more readily
available to traders with the current standard software.
There is a mystique that surrounds this simple tool, and
many traders shun it because they dont understand its concept. There are many things that linear regression can and
cannot do in explaining the concept of trend. Linear regression will not solve all of the problems of analyzing trends, but
understanding the nature of the indicator and the ancillary
statistics associated with its computation will provide a better
understanding of market dynamics.

A LOOK AT MOVING AVERAGES

Most traders use simple moving averages, so lets take a look
at the strengths and weaknesses of moving averages as a trend
indicator and compare them with the linear regression method.
Moving averages are essentially a smoothing technique.
By averaging past data, the moving average filters the noise
associated with any time series datastream. This is true
whether you are observing daily, hourly, monthly or any
discrete data.
Moving averages present two fundamental problems for
analysts. First, the average is just that an average price that
should be plotted or centered midway through the data
interval. If a 20-day simple moving average is being used, the
result is the average price of the data centered on the data 10

days back. Most technical analysis programs will shift the

result to be current with the day or week. Conceptually, trends
persist, and the moving average is the proxy for the
current trend. As long as your current data is above the
moving average and the moving average is rising, the
trend is up. If the current data is below a falling moving
average, the trend is down. Numerous variations of this
technique exist, and many traders have employed them at
one time or another.
The second problem with moving averages is the arbitrary
selection of the lookback period. The selection of the interval
depends on the traders requirements and the attributes of the
market in question. Short intervals are responsive to market
changes and retain much of the noise that the average seeks
to eliminate, while long intervals eliminate much of the noise
but are not particularly responsive to the market movement.
Traders have devised many systems to correct these problems, but that discussion is beyond our scope here.
There are some secondary problems with moving averages
that can be just as important as the primary ones. First, there
is no method to measure the slope of the trend directly
without resorting to some data manipulation. Second, there is
no direct method to determine if the data fits the market
studied (otherwise known as goodness of fit), and finally,
there is no direct way to measure whether the prediction
falls within a measurable acceptable error. These problems can be solved to some degree with additional indicators, but there is a more elegant and superior solution, and
that is linear regression.

ABOUT LINEAR REGRESSION

Linear regression is a statistical technique that fits a straight
line to a datastream. The datastream is an independent variable versus a dependent variable. In this case, the independent variable is time and the dependent variable is price. This
data is generally viewed in a scatter diagram, but here, we use
traditional price charts with just the closing price plotted on
the y-axis, and the x-axis being time. A straight line is fitted
so the distance is minimized between the predicted line and
the data, a technique referred to as least squares. The name
comes from the use of squaring the differences between the
line and the data points. For our purposes, I will simply refer
to the technique as linear regression.
Some very valuable statistics are a byproduct of linear
regression analysis: r-squared or the coefficient of determination, the standard error of the estimate, the slope of the line
and finally a prediction. While I will address each of these, I
will focus on the r-squared as our basic tool for trend
determination. The use of this readily available statistic will
aid trend analysis and help determine when trend trading

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techniques should be used.

R-squared is the key statistic generated when a linear
regression line is fitted. This statistic informs us how well the
line explains the data; the parameters for this statistic are zero
and 1. A reading of zero indicates that the dependent variable
has no linear relationship to the independent variable, while
an r-squared reading of 1 indicates that the line explained the
data exactly.
High readings indicate good trends and low readings
denote a nontrending or ranging market. Observing how rsquared behaves will give an important clue about refining our

trading patterns whether we should be using trend-following methods or range trading methods at any given time.

USING R-SQUARED
R-squared is used to measure the relationship of variables in
an equation. Econometricians use r-squared to estimate how
well equations or models fit the data. In multiple linear
regression, each variable makes a contribution to the equation and the result of each new variable can be measured.
Observing r-squared as it moves through time provides us
with useful trading information as the indicator can range

Copyright (c) Technical Analysis Inc.

CHRISTINE MORRISON

Stocks & Commodities V16:4 (173-179): Identifying Market Trends by Jack Karczewski

Stocks & Commodities V16:4 (173-179): Identifying Market Trends by Jack Karczewski

25

35
30

20

15

PRICE

PRICE

25

10

20
15
10

5
5
0

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

TIME

TIME

FIGURE 1: A NONTRENDING MARKET. Heres a simple close-only chart with a

linear regression line plotted though the data. The price action is sideways, moving
over the period of 30 observations. Relative to time, the market is not trending.

FIGURE 2: A TRENDING MARKET. Heres a chart similar to Figure 1, except the

price is rising at a fairly constant pace. The r-squared indicates that the data is
moving almost as a straight line over time.

from zero to 1, so indicating the degree of trend. Figure 1

shows a simple close-only chart with a linear regression line
plotted though the data. The price action is sideways, moving
over the period of 30 observations. The r-squared for the data
is 0.00014, which is close to zero. This value indicates that
relative to time, the market is not trending.
Figure 2 shows a similar price chart, except the price is
rising at a fairly constant pace. The data has an r-squared of
0.95, indicating that the data is moving almost as a straight
line over time. Figure 3 shows both types of periods. A trend
is developing, and you can see the r-squared climb in value
as the market trends. As the market peaks and moves into a
consolidation, the r-squared falls in value, setting the stage

for a new trend. In both situations, the r-squared provides a

quantifiable method to measure the relationship between
price and time. This relationship enables the trader to make
important decisions about the trends longevity, a departure
from classical analysis of trends.
Time is the independent variable in this type of analysis; no
inference should be drawn that time is the causation for the
movement in the dependent variable in this case, price.
Fundamental and exogenous factors contribute to the movement of the independent variable, but this technique is not
concerned with them. Like any indicator or technique, there
is a certain method to applying this statistical tool.
Figure 4, the Standard & Poors 500 index, shows a visual

S&P 500 INDEX

Anatomy of A Trend
Trend breaking down

TRADESTATION (OMEGA RESEARCH)

Consolidation or reversal

Trend developing
Trending

r-squared
Trending
No trend to trending

From trend to no trend

Transition
Nontrending

FIGURE 3: THE ANATOMY OF A TREND. This chart shows both types of periods.
A trend is developing, and you can see the r-squared climb as the market trends.
As the market peaks and moves into a consolidation, the r-squared falls in
value, setting the stage for a new trend. In both situations, the r-squared
provides a quantifiable method to measure the relationship between price and
time. This relationship enables the trader to make important decisions about
the trends longevity.

FIGURE 4: S&P 500. Heres a visual representation of r-squared plotted through

time. The interval used for this indicator is 30 trading days, which was selected
because it is the smallest number of observations that can be used without
correcting for small samples. Longer or shorter lengths can be used, but smaller
samples will need to be corrected for statistical significance, while longer
lengths suffer from the same problems as moving averages; they are not
responsive to short-term influences in the market. The intervals should be
adjusted to the traders time horizon.

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Stocks & Commodities V16:4 (173-179): Identifying Market Trends by Jack Karczewski

R-SQUARED READINGS, S&P 500

R-squared Cum. occ. Int. occ. Frequency Condition Cum freq.
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0

488
679
862
1026
1204
1391
1618
1892
2174
2234

488
191
183
164
178
187
227
274
282
60

22%
9%
8%
7%
8%
8%
10%
12%
13%
3%

No
Trend
39%
Transition

Trending

fashion, with the exception of spring and summer 1997.

Extreme readings are associated with changes in the
markets. Once such readings are observed, they tend to
reverse, though not at predictable periods. Still, it is useful
to know when a market is trending. In fact, r-squared could
be the most important variable associated with linear regression analysis; without an r-squared reading, the validity
of the line remains undetermined.

38%

FIGURE 5: Some inferences about trading conditions may be made by studying rsquared readings. Figure 5 shows a distribution of r-squareds; these readings were
taken from 30-day linear regression analysis of the S&P 500 index from August
1988 to summer 1997. Readings of greater than 0.70 describe a good fit, while
readings of less than 0.30 describe a poor one. At first glance, the numbers would
seem to indicate that the market does not trend as often as we would like. The
statistics suggest that the S&P 500 is in a trending mode only about 35% of the time.

representation of r-squared plotted through time. The interval used for this indicator is 30 trading days, which is about
42 calendar days. The period of 30 days was selected because
it is the smallest number of observations that can be used
without correcting for small samples. Longer or shorter
lengths can be used, but smaller samples will need to be
corrected for statistical significance, while longer lengths
suffer from the same problems as moving averages; they are
not responsive to short-term influences in the market. The
intervals should be adjusted to the traders time horizon.
It should be noted that the indicator is unstable; it is very
dynamic, does not remain in the same location for extended
periods and frequently oscillates between zero and 1. Of
further note is the manner in which it traverses the entire
range from low to high and has completed these in a cyclical

S&P 500 INDEX

Since linear regression is a measure

of past performance, is there a
method that can be used to help with
trading? There is: the average
length of the run can be used to play
the odds in using linear regression.
THE NATURE
OF R-SQUARED
Some inferences about trading conditions may be made by
studying the nature of trends, identifiable with r-squared.
Figure 5 is a distribution of r-squared readings. These readings were taken from 30-day linear regression analysis of the
S&P 500 index from August 1988 to summer 1997. Readings of
greater than 0.70 describe a good fit, while readings of less than
0.30 describe a poor one. While some might argue that these are
arbitrary levels, they are nevertheless a point of departure. And
unlike some other indicators with points that trigger action, these
numbers are derived from statistical theory.
At first glance, the numbers would seem to indicate that the
market does not trend as often as we would like. The statistics
suggest that the S&P 500 is in a trending mode only about

S&P 500 CASH

Market action consistent with r-squared indicator

This run lasted 65 days,
the longest during the period
under observation.
r-squared

r-squared (0 7104)
Market failed to achieve an r-squared of greater than 0.7 for 204 market days

FIGURE 6: CONSECUTIVE DAYS IN A TREND. The number of days the r-squared

spends at certain levels are referred to as runs. Runs are defined as consecutive
days in a trend. If a market achieves an r-squared reading of greater than 0.70 and
the following day has another day of greater than 0.70, that would be a run of two
days. The longest run in the S&P 500 of a trending market has been 65 days; that
run ended in August 1997.

FIGURE 7: CONSECUTIVE DAYS NOT IN A TREND. Contrast that information with

the longest period that a market was not in a trend. That was 204 days, which ended
in November 1992. The next longest period of r-squared of less than 0.70 ended in
July 1996, and that was 102 days. This information may be why many moving
average systems fail.

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Stocks & Commodities V16:4 (173-179): Identifying Market Trends by Jack Karczewski

35% of the time. If the trend is your friend, it is a very fickle

one, because it doesnt stay with you very long.
While this is useful information, it is only part of the story.
By observing the nature of the movement of r-squared, in
Figure 5, we can see that it moves from nontrending to
trending conditions.

RUNS
Figure 5 gives us information about the distribution of trends
and nontrends, but what about the number of days the rsquared spends at certain levels? These are referred to as
runs. Runs are defined as consecutive days in a trend. If a
market achieves an r-squared reading of greater than 0.70 and
the following day has another day of greater than 0.70, that
would be a run of two days. The longest run in the S&P 500 of
a trending market has been 65 days (Figure 6); that run ended
in August 1997. The next largest runs were 55 days, which
ended in June 1995, and 38 days, which ended in March 1995.
Contrast that information with the longest period that a
market was not in a trend. That was 204 days, which ended
in November 1992 (Figure 7). The next longest period of rsquared of less than 0.70 ended in July 1996, and that was
102 days. The trend is certainly not your friend with numbers like these. This information may be why many moving
average systems fail.
This is not to suggest, however, that moving average
indicators are no longer useful. Linear regression has in
common with moving averages a shortcoming, and that is the
difficulty in selecting the correct interval or length of the
lookback period. With linear regression, it is clear when the
line no longer fits the market, but with a moving average, the user
must rely on the market trading below or above the moving
average for that information. Figure 8 summarizes the major
differences between moving averages and linear regression.

EARLY WARNING SIGNS

Since linear regression is a measure of past performance, is
there a method that can be used to help with trading? There
is: the average length of the run can be used to play the odds
in using linear regression. STOCKS & COMMODITIES Contributing Editor Tushar Chande first proposed an indicator to
observe the errors that are generated about the regression
line. If a market has a very low r-squared reading, then this
market is trading within a consolidation or congestion phase.
In this instance, the usual statistical indicators are not useful,
except for what they are not telling you. Because low or high
r-squared readings are fleeting, perhaps the place to look for
the start of trends are markets exhibiting these conditions.
This supports traditional technical analysis regarding
breakouts from congestion or trading ranges.
For example, observe how the errors started to occur on the
positive side in Figure 9 when there was a low r-squared
reading in the Russell 2000 index. The errors have been
adjusted to reflect a percentage error from the actual. This has
no significant statistical inference, but it does help in visualizing the size of errors. This technique is useful, because

LINEAR REGRESSION VS. MOVING AVERAGES

Attribute

Linear
Regression

Moving
Average

Indicates strength of trend

Direct reading of slope
Standardized errors

Yes
Yes
Yes

No
No
No

Interval indication (length)

Exponential (parabolic) move

No
No

No
Yes

FIGURE 8: Linear regression has in common with moving averages the

difficulty in selecting the correct interval or length of the lookback period.
With linear regression, it is clear when the line no longer fits the market,
but with a moving average, the user must rely on the market trading below
or above the moving average for that information. Figure 8 summarizes
the major differences between the two.

while the linear regression gives information about the previous 30 days, the trader has to make an inference about the
market going forward. Observing the errors can give you that
early warning signal. The errors can be stated simply as:
((Actual-Predicted)/Predicted)) 100

ADDITIONAL
TRADING AIDS
Since the r-squared indicator
doesnt identify whether the
market is in an uptrend or a
downtrend, it is useful to paint
the bars to mark them as one or
the other if the r-squared
reaches 0.70 or higher. This may be accomplished by plotting
the slope of the regression line, but actual crossing to an up- or
downtrend is more dramatic and gives a visual reference.
Figure 10 is of the March 1998 Treasury bond futures, in
which the bond futures have been in an uptrend, punctuated
by brief downtrends. These changes of trend are accompanied
by low or zero r-squared readings. By definition, an r-squared
of zero indicates that the statistical methodology indicates no
trend is present. This is what technicians define as consolidation, and they can occur at tops or bottoms.
Another example is Figure 11. This is the TYX, the 30-year
interest rate, disseminated by the CBOE in real time. Note the
extended period that it has been in a downtrend, indicating rates
are moving lower. This is a market with sharp reversals, usually
caused by surprises in the monthly unemployment report. This
report often sets the tone of the bond market for the coming
month; careful analysis of the trend along with r-squared can
often yield valuable information about the coming months.
Figure 12 is Ascend Communications, a stock that has
fallen from a high in the low 80s to the low 20s in less than a

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Stocks & Commodities V16:4 (173-179): Identifying Market Trends by Jack Karczewski

These errors often will be an

early warning of a reversal

LR Errors

These are percentage

deviations from predicted

RUSSELL 2000

Market consolidates move from lows,

generates low r-squared, moves into
downtrend, generates high r-squared
and reverses once again.

This was a very strong trend,

as evidenced by the
high sustained r-squared
Arrows indicate possible trend reversals
r-squared

Trend change possible

FIGURE 9: ERRORS, RUSSELL 2000 INDEX. Observe how the errors (top) started
to occur on the positive side when there was a low r-squared reading in the Russell
2000 index. The errors have been adjusted to reflect a percentage error from the
actual. This helps visualize the size of errors. This technique is useful, because
while the linear regression gives information about the previous 30 days, the trader
has to make an inference about the market going forward. Observing the errors can
give you that early warning signal.

FIGURE 10: MARCH 1998 TREASURY BONDS. Here, the bond futures have been
in an uptrend, punctuated by brief downtrends. These changes of trend are
accompanied by low or zero r-squared readings.

year. The red bars in TradeStation represent a negative linear

regression slope. See how the market reacts when the rsquared reading approaches zero. Look what occurred in
early December when the market consolidated, and reversed
from down to up. The bar changed color on what appeared to
be a downtrend. The stock had a very large upmove in just a
few days before settling back down again.
As of this writing, the stock has a very low r-squared and
appears to be making another transition. This time, the stock
has broken a short-term trendline and could be ready for a

significant move to the upside. When a situation like this is

encountered, it is best to let the market lead.

FIGURE 11: 30-YEAR TREASURY BONDS. Note the extended period that the TYX
has been in a downtrend, indicating rates are moving lower. This is a market with
sharp reversals, usually caused by surprises in the monthly unemployment report.
This report often sets the tone of the bond market for the coming month; careful
analysis of the trend along with r-squared can often yield valuable information about
the coming months.

FIGURE 12: ASCEND COMMUNICATIONS. Heres a stock thats fallen from a high
in the low 80s to the low 20s in less than a year. The bars, whick are red in
TradeStation, represent a negative linear regression slope. See how the market
reacts when the r-squared reading approaches zero. Look what occurred in early
December when the market consolidated, and reversed from down to up. The bar
changed color on what appeared to be a downtrend. The stock had a very large
upmove in just a few days before settling back down again.

FURTHER
CONSIDERATIONS
This technique is the linear part of the regression. If a market
is in some power exponential move, a straight line isnt going
explain that market; at least youll be aware that the market is
in a powerful move. The r-squared reading will, if nothing
else, alert you to look to other methods for trading assis-

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Stocks & Commodities V16:4 (173-179): Identifying Market Trends by Jack Karczewski

FIGURE 13: CYPRESS SEMI-CONDUCTOR. This chart illustrates the use of

different lookback periods. The gray r-squared indicator is a 63-day linear regression and the black line is a 21-day linear regression. Note how the shorter-term rsquared cycles within the longer interval. Powerful moves tend to occur at high or
low r-squared readings when the long and short r-squared indicators coincide. Just
such a coincidence occurred in mid-December 1997, on a day when the stock was
making new yearly lows.

FIGURE 14: CYPRESS SEMI-CONDUCTOR, IN A DOWNTREND. The stock is

clearly in a downtrend; in fact, it may have bottomed and is now in the process of
moving sideways to up, which will reduce the current high r-squared reading.

tance. Multiple time periods for the linear regression might

be of help, similar to the method used in moving average
crossovers.
Figure 13, Cypress Semi-Conductor, illustrates the use of
different lookback periods when assessing the trending nature of a stock or market. The gray r-squared indicator is a 63day linear regression and the black line is a 21-day linear
regression. Note how the shorter-term r-squared cycles within
the longer interval. Powerful moves tend to occur at high or
low r-squared readings when the long and short r-squared
indicators coincide. Just such a coincidence occurred in midDecember 1997, on a day when the stock was making new
yearly lows. It also appeared that the stock might have also
had a key reversal.
Figure 14 shows the stock is clearly in a downtrend; in fact,
it may have bottomed and is now in the process of first
moving sideways to up, which will reduce the current high rsquared reading. If you choose to wait for a clear uptrend to

occur, a low-risk trading opportunity may be lost. This is

where a skillful trader can make a reasonable snap judgment
by having useful statistics on hand. Using those statistics
allows us to determine that this is not a good trending stock
and so must be traded to extract maximum profits.
When using this technique, it is invaluable to study the
frequency distributions of r-squared in order to make reasoned judgments about where the market will be headed in
the future. Its true what they say: Those who do not study
history are doomed to repeat it.
Jack Karczewski is a Paine Webber broker in Scottsdale, AZ.

RELATED READING
Chande, Tushar [1992]. Forecasting tomorrows trading
day, Technical Analysis of STOCKS & COMMODITIES,
Volume 10: May.
See Traders Glossary for definition

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