Forex Trade – Intelligent Forex

Understanding Standard Deviation For Bigger FX Profits

Posted in Forex Education by intelligentforex on January 8, 2010

If you ask most Forex traders what standard deviation of price is you will me met with a blank look but understanding it is essential Forex education which if you know its significance and use it, can help you make bigger forex profits…

To show how valuable understanding it is – I once saw a trading system that only used standard deviation to generate trading signals and in just a couple of years, it went from a $100,000 to just over $1.1 million, in real time trading, simply trading changes in volatility.

Lets take a look at it in more detail, how to calculate it and a trading indicator to help you apply it in the markets.

What is Standard Deviation?

Standard deviation of price is the term that is used to statistically measure the volatility of price in any financial market (not just forex) and gives a view of how widely values (closing prices) are dispersed from the average price.

Dispersion is simply the difference between the actual value (present closing price) and the average value or mean closing price.

The wider the difference between the actual value and average value the higher the standard deviation will be. Standard deviation therefore gives you an overall view of market volatility and dealing with market volatility is one of the major challenges any financial trader has to deal with

Measuring Standard Deviation

To measure standard deviation and see how volatile a market is you do the following calculation:

Take the square root of the variance, the average of the squared deviations from the mean and you have the standard deviation.

If you find it a little confusing at the moment don’t worry as there are visual indictors you can use which will show it to you in simple terms and you don’t need to know the calculation to use it.

The Importance of Volatility

When markets are very volatile standard deviation will be high and when they are for example trading in ranges standard deviation will be low and you can see it historically and use it in your trading

Using It in Your Forex Trading Strategy

It’s a fact that periods of high volatility (price spikes) don’t last long and you can see this in any market and prices will normally return back to the longer term average. Price spikes are normally the result of the emotions of greed and fear as we as traders push prices to far either up or down.

Generally you can use standard deviation in the following way

High standard Deviation Won’t Last

When price spikes occur and standard deviation is high historically, you can look to take profits or enter contrary trades against the spike.

Buying the Average

Prices will always tend to dip back to the average in strong trending markets and this is an opportunity to load up trades in the direction of the trend.

Low Standard Deviation Moving to High and New Trends

When a market is not volatile and features low standard deviation and it turns higher you will very often see a new trend develop and it’s an advance warning to get ready to execute a trading signal.

A Visual Tool to Measure Volatility

A very useful tool which gives you a visual view of standard deviation and volatility is the Bollinger Band and every trader should be familiar with it.

Bollinger bands are volatility bands which are drawn either side of a simple moving average and combine a simple moving average with the volatility of the individual market in a trading envelope.

The outer bands show you the volatility and the simple moving average gives you the long term value of the market. You therefore can see how volatile the market is historically via the outer bands and see the value of the market at the centre band.

Just simply using the outer bands to decide when to take profits and enter new positions and buying or selling back to the moving average can be highly effective.

We will look at Bollinger Bands in more detail in the next article of essential forex education and how you combine them with momentum indicators to generate trading signals and improve your market timing.


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