Hi, everybody. Forex is the largest and most liquid among global financial markets. Recognized for its daily trading volume in the trillions of dollars, Forex is a financial market that offers us the opportunity to exchange different countries' currencies. One of the analysis methods required to achieve good results in trading this market is technical analysis. Technical analysts attempt to find trends, support and resistance levels, and other patterns from past price movements using charts, indicators, and other technical tools. By using this information, they predict future price movements. There are many technical analysis tools used in financial markets, and we can add technical indicators to that list. Indicators function as mathematical tools, allowing us to measure trends, momentum, and other price movements by examining past price actions. The Standard Deviation Indicator is the subject of today's article.
What is a Standard Deviation (SD) Indicator?
The Standard Deviation (SD) indicator is a statistical measure of market volatility. It shows how much the price of an asset deviates from its average price over a selected period. A high SD value indicates high volatility (prices are spread far from the mean), while a low SD value signals low volatility (prices stay close to the mean).
The term "Standard Deviation" that we often meet in financial markets is generally used to measure volatility and assess the predictability of price movements. Standard deviation measures how much the prices of a financial instrument usually deviate from the average. The higher the standard deviation, the more volatile and unpredictable the prices become. When trading in the Forex market, we can utilize standard deviation in various ways. For instance, we can use it to predict how much an asset's price is likely to change over a specific period. Also, we consider it when evaluating the probability of an asset's price rising or falling. High volatility means that the currency or asset's price may experience faster and larger fluctuations.
Calculation of Standard Deviation
Measuring volatility and evaluating the predictability of price movements in financial markets require the calculation of standard deviation. Standard deviation is a measure indicating how much the prices of a currency pair fluctuate within a specific period. The first step involves recording the closing prices of a particular currency pair over a period, for example, 20 days. Then, the average value of these closing prices is calculated. To compute the average value, the sum of these prices is taken and divided by the number of periods. To determine how much each closing price deviates from the average value, each price is subtracted from the average. The squared values of these deviations are calculated. The resulting squared deviation values are summed, and this sum is divided by the number of periods. Finally, the square root of this value is taken to calculate the standard deviation.
Here is the formula used to
calculate standard deviation:
σ = √((1/N)Σ(Xᵢ - μ)²)
In this formula:
- σ represents the standard deviation.
- ∑ represents the sum.
- N is the total number of days in the period used (e.g. 20 days)
- Xi, each day's closing price
- μ is the average value of the period's closing prices.
Don't worry, we don't need to perform these complex
calculations ourselves, standard deviation is automatically calculated and
displayed by trading platforms and software. Standard deviation is a
measurement used to gauge how erratic the price movements of a currency pair
are. A higher standard deviation value indicates that the currency pair's price
is as erratic as ocean waves, while a lower value suggests that the currency
pair's price is as stable as a calm lake.
The Standard Deviation indicator is one of the most widely used volatility measures in technical analysis. Traders rely on the Standard Deviation indicator formula to quantify how much an asset’s price deviates from its mean over a specific period. When building a trading strategy, many analysts start by applying the Standard Deviation indicator formula with a default period of 20, just like Bollinger Bands do. The Standard Deviation indicator formula is simple yet powerful: it calculates the square root of the variance, where variance is the average of the squared differences from the mean.
How to use the Standard Deviation indicator?
Standard Deviation is more commonly used in trading in financial markets to assess volatility and improve risk management strategies. Standard deviation measures how volatile and how frequently the prices of a currency pair change. A high standard deviation indicates high volatility, suggesting that prices fluctuate more. On the other hand, a low standard deviation reflects a more stable market environment. During this time, we can use standard deviation to determine which currency pairs have higher volatility. When investing in a currency with a high standard deviation, we take more risk, while investing in a currency with a lower standard deviation involves less risk. This helps us manage our trading risk.
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| Standard Deviation on the AUD/NZD chart |
In addition, standard deviation can be used to assess
whether the prices of a currency pair will trend or reverse. If standard
deviation is increasing, it indicates that the price trend is strengthening. If
you observe a trend with high standard deviation, the trend is more likely to
continue. Conversely, if you see a clear deviation in prices with high standard
deviation, it could be a signal of a reversal. Indicators are used to determine
optimal entry points by tracking price movements. Standard deviation, on the
other hand, evaluates how much the current prices deviate from the average
price, so we can estimate the probability of prices returning to the average
value in the future.
Many professional traders incorporate a Standard Deviation trading strategy into their daily routine because it helps them objectively measure volatility and identify overextended markets. A classic Standard Deviation trading strategy revolves around Bollinger Bands, where you buy when price touches the lower band (–which is placed at 2 standard deviations below the moving average–and sell when it reaches the upper band. Another popular Standard Deviation trading strategy is the “squeeze” setup. When the Bollinger Bands contract dramatically (showing very low standard deviation), traders wait for the breakout. This Standard Deviation trading strategy performs especially well in markets that alternate between low-volatility consolidation and high-volatility trends.
Some traders prefer a pure Standard Deviation trading strategy without relying on Bollinger Bands at all. For example, one simple yet effective Standard Deviation trading strategy is to go long when the 20-period standard deviation drops below its 100-period moving average of standard deviation (indicating unusually calm conditions) and then rises sharply, signaling an impending volatility expansion. Mean-reversion enthusiasts often use a Standard Deviation trading strategy based on z-scores. They calculate how many standard deviations the current price is away from the mean and take positions only when the z-score exceeds +2 or falls below –2, expecting price to revert to the average.
Finally, risk managers love the Standard Deviation trading strategy for position sizing. A common rule in such strategies is to reduce position size when current standard deviation is significantly above its historical average, and increase exposure when volatility is historically low. In short, whether you combine it with moving averages, RSI, or use it standalone, a well-defined Standard Deviation trading strategy remains one of the most versatile and statistically sound approaches in modern technical trading.
Keep in consideration. As a metric for measuring volatility and analyzing price movements, Standard Deviation is a proven indicator in the context of financial market trading. This indicator can be a useful tool for market analysis, but it cannot fully capture the complexity of price movements. Market dynamics are dependent on a variety of factors, and a single indicator can only provide a limited view. Standard Deviation can sometimes give false signals. It can be risky to use the indicator, especially during periods of low liquidity or under the influence of news. Relying solely on the Standard Deviation indicator in trading leads to the incompleteness of your risk management strategies. It is important to combine standard deviation with other technical indicators to achieve better results when trading in financial markets. Trading success to you!