Understanding Standard Deviation for Bigger Profits
In forex trading the vast majority of novice forex traders don’t understand the concept of standard deviation, but they should – as it is essential Forex education and will lead you to bigger profits. You will gain greater insight into price movements and how to trade these currency trends for profit.
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Let’s look at the concept of standard deviation and how it can help you in your forex trading strategy. Let’s do the technical bit first and how to apply it. Later we will look at how to apply it and it’s advantages.
Defining Standard Deviation
Standard deviation is a statistical term that provides an indication of the volatility of price in any investment and that includes currencies. Don’t worry if you find the next bit confusing - it will become clearer as we get to the end of the article.
Standard deviation measures how widely values (closing prices) are dispersed from the average price. Dispersion is the difference between the actual value (closing price) and the average value (mean closing price). The larger the difference between the closing prices and the average price, the higher the standard deviation will be and therefore the volatility of the market. The closer the closing prices are to the average mean price, the lower the standard deviation and the volatility of the currency is.
Standard deviation is calculated by taking the square root of the variance, the average of the squared deviations from the mean. High Standard Deviation values occur when the data item being analyzed is changing dramatically and volatility is high. Conversely, low Standard Deviation values occur when prices are more stable and moving within tight ranges. Major tops and bottoms always feature high volatility as investor emotions are to the fore and greed and fear drive prices.
Using Standard Deviation
Most short term price spikes that move too far from the mean price are unsustainable and prices normally “blow off” at highs or lows and return to the mean average. High standard deviation can be a great way to spot important market highs or lows. You can then use other technical indicators to generate trading signals to enter the forex markets when the risk is lowest and the rewards are highest.
A big rise in volatility away from the mean, i.e. a spike is normally driven by human emotion and the odds of prices returning to the average are high. It’s therefore a great way to generate contrary trades.
It's also great for trend followers. For example, if you have a market that features low volatility and you see an important price break accompanied by a spike in volatility, then chances are the trend will continue. Again you enter the trade with the odds on your side.
Standard deviation can also be used to buy into support (the mean) and can generate profit taking signals and can also help you set stops. If you understand volatility and standard deviation of forex prices, you will be able to trade with higher profit potential and lower risk.
Bollinger Bands
A simple way of looking and taking advantage of standard deviation when trading currencies is to use Bollinger bands. If you incorporate them in your currency trading system you will gain an extra edge in your quest for forex profits. Check out our article on Bollinger bands and how to use them – if you have never used them before, you will be glad you found them.
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