Standard deviation is a concept that every trader needs to understand when it comes to dealing with any asset in the market. As a matter of fact, if you do not comprehend it and how to implement it in your trading strategy, it will be hard to succeed in the long haul. Standard deviation is logical, relatively easy to learn, and will help you in better timing entries and define your targets, not to mention spotting trend reversals. It is a powerful but simple concept that every forex trader needs to know how it works and how to leverage it. Overcoming volatile price moves is a real issue that traders have to deal with in the FX market, and if you learn how to deal with standard deviation in forex, you’ll enter trades with better risk-reward and won’t get stopped out as often.
What is Standard Deviation?
Introduced by the mathematician Karl Pearson in 1894, the standard deviation is a device that refers to and shows the price volatility of a financial instrument. In essence, it measures the distance between a data point and the mean value at a particular time.
Here is the standard definition of standard deviation:
- It is the square root of the variance of value and is symbolized by the Greek letter sigma.
- The average of every squared difference from a pre-defined mean is what we refer to as variance, and it’s symbolized by the letter sigma squared.
- The mean is calculated by adding up all data set values and dividing by the total number of instances. Simply put, the mean is a simple average and is often represented by the greek letter Mu.
One of the best things about standard deviation is that it makes data interpretation intuitive. Small deviation values show low variability, while large deviations represent high variability.
This information is particularly helpful in quantifying pricing volatility, at a set’s dispersion and also in forex.
Standard Deviation in Forex Trading
The concept of volatility is vital in quantifying risk and opportunity in options, futures, bonds, and stock pricing.
The market structure greatly depends on the relative price movements, be in a compressed, range-bound, or trending situation. This makes having a technical indicator like standard deviation vital in making these determinations more efficiently.
When it comes to FX trading, periodic exchange rates dispersion can be interpreted in three fashions: high, normal, and low.
Each designation shows an inherent level of pricing volatility in a financial instrument or currency pair. With the standard deviation calculated, you are in a better position to make strategic considerations.
That being said, here’s a more in-depth look at the ways standard deviation interpretation is made in forex trading:
A high standard deviation reading shows that price volatility is high. This is often accompanied by robust price action, heavy participation as well as wide periodic ranges.
Currency pairs that show high volatility put traders in a dilemma, as the increased price action leads to an increase in both the potential reward and assumed risk. Due to the potential of huge gains, trend reversal and following strategies are often implemented.
Low deviation levels show that the market is in consolidation and that the price action is compressed. As a result, FX traders may decide to adopt rotational trading strategies like ‘reversion to the mean’ approach.
When you adopt this strategy, the opposing position is taken from the appearance of a periodic extreme. As such, profit is sought by the price going back to its mean value or relative average.
A normal standard deviation shows that the market is acting as expected. In such a situation, a wide array of strategies are warranted, including pivot-point, range trading, and scalping.
Each of the standard deviation rankings mentioned above comes with a set of benefits and challenges and ultimately, it’s up to you to decide which pricing volatility levels are ideal for a certain trade.
Implementation of Standard Deviation in Forex
Addressing the exchange rate volatilities of financial assets is a vital element when it comes to FX trading. The ability to identify when markets are consolidating or trending is a crucial skill and one that’s mostly aided by standard deviation indicators.
Forex trading platforms typically feature standard deviation indicators, and the most commonly used ones include:
Also referred to as BBs, Bollinger bands are a technical indicator that represents price volatility by producing upper and lower bands. The deviation is a vital input in BBs calculation, as it determines the width of the Bollinger bands.
This is the application of deviation after currency exchange rate pricing. It’s derived by taking a simple set of price points and then calculating the variance, mean, and deviation.
STDEV is commonly represented as a graphing overlay, and it gives you a visual representation of the dispersion of price from a given mean value.
As with most indicators, those that are based on deviation are best used in conjunction with other tools. Devices like momentum oscillators, time price offering charts, and Fibonacci retracements tend to prove quite useful.
The deviation is a widely accepted technical indicator in the forex market. It is easy to interpret and can be automatically applied.
Calculating standard deviation values manually can be very time consuming, but thanks to modern technology, there’s no need for that.
All technical indicators describe above are usually included in all trading systems (Meta Trader or other). Therefore, every trader can take advantage of tools such as STDEV and Bollinger bands to get those important values.