R-Squared Method in Forex Trading

Written by Miroslav Marinov

Miroslav Marinov

Miroslav Marinov, a financial news editor at TradingPedia, is engaged with observing and reporting on the tendencies in the Foreign Exchange Market, as currently his focus is set on the major currencies of eight developed nations worldwide.

, | Updated: October 30, 2024

This is a linear regression method, which attempts to determine the strength of trends. If prices move in a straight line more closely during a certain period of time, this suggests that the trend will be stronger. R-Squared readings reflect the percentage of price movement in terms of linear regression. In case the R-Squared reading during 14 periods is at 60%, this indicates that 60% of the price move can be explained using linear regression. The remaining 40% is considered as random noise.

A trend is statistically significant for a linear regression line of a certain period, if we have a confidence level of 95%. In case the R-Squared reading is below the 95% confidence level for a particular period, then there is no statistically significant trend.

Below the recommended number of R-Squared periods and the corresponding 95% confidence levels are shown.

Number of Periods / R-Squared Critical Value equal to 95% Confidence:

5 / 77
10 / 40
14 / 27
20 / 20
25 / 16
30 / 13
50 / 8
60 / 6
120 / 3

Linear regression and R-Squared can be used in several ways in order to generate trading signals. One of the approaches combines the R-Squared with the Linear Regression Slope. The R-Squared will determine how strong the underlying trend is, while the Linear Regression Slope will determine the direction of the trend – whether it is positive or negative. Signals will be produced in accordance with the direction of the Linear Regression Slope, while the R-Squared should remain above its 95% level of confidence.

Another approach combines the R-Squared with an oscillator. In this case signals will be produced in accordance with the oscillators readings between the overbought and the oversold levels, while the R-Squared should remain at low levels (significantly below the 95% level of confidence, which suggests that markets behavior is ”less trendy”).

Chart Source: VT Trader