The Standard Deviation is a trend-type indicator used for trading.
In this case, it is a somewhat ambiguous indicator because I do not know why it is called a trend, when in reality it is useful for measuring volatility.
In fact, we cannot know much about the trend with it, except to suspect that it has changed a lot due to important changes in the indicator.
Therefore, it is not an indicator that helps us make market predictions, since it will not tell us if we are over-bought or over-sold.
As we can understand, we are dealing with a statistical concept that takes a certain period and calculates the standard deviation of the prices using the moving average of the same.
So we are talking about an indicator of volatility, rather than trend.
We will use the same to determine when the market can change direction and it is possible that it could give us some signals in a bear market on the stock market.
That is, I think it is an indicator that if applied, we could do well in stocks but hardly in Forex.
Why do I say that Standard Deviation is better for predicting movements in the stock market?
For a simple reason, because the stock market is a market that tends to rise in the long term, as everyone knows.
This market has a low volatility, that is, there is little fear in the stock market, when things go well, for example when the economy grows, and with this the prices of shares tend to rise.
However, as we know, this volatility – the fear of investors – raises a lot when business results are or are expected to be bad, which in this case would increase the Standard Deviation.
We can see this perfectly in the chart of the SP & 500 in which we see that this indicator increases dramatically every time there is a correction to the downside.
This, although it seems silly, could serve as a reference to perform operations.
But before that, I am going to comment on why this indicator is not the best indicator for other instruments such as Forex.
Standard deviation in the Forex
As we see in the pair king of the currency markets: the EURUSD, in this case increases in volatility can be associated with increases or falls in the pair, which does not give us any reference in this regard.
That is, there may be increases in volatility when the EURUSD increases or also when that pair falls.
Therefore it is totally futile to try to apply a strategy with this indicator, or at least from the point of view with which we can do it in the stock markets, either in indices or particular stocks.
Calculation of this indicator
First we have to calculate the average price of the asset for a period n.
Then we will have to calculate the deviation of each period, which is the closing price minus the average.
Then we square that deviation.
Later we add these deviations of n periods and divide it by the same n.
At the end we will have the Standard Deviation of the period N.
If you look, this indicator will give us different results depending on the price of the asset.
For example, if we do the calculation on Amazon – at today’s prices – we can have values around 40, and if we do it with the BBVA at 0.20.
As we see, when an asset has a very high price of 1,800 like Amazon, the result is very different from another that is for 3 or 4 euros or dollars.
That is, we cannot take absolute values of this indicator to work with all assets.
We could look for some way to soften this difference if we apply the deviation in percentage terms, but here I will continue with the classic indicator.
Use of standard deviation in trading
From my experience, I can say that the best way to use this indicator is to bet on upside values when there is low volatility or downwards values when there is a lot of volatility.
Also, it is an indicator that works better with instruments of the index type, which have much smoother movements, because in particular stocks we have many occasions in which there are increases with a tremendous volatility, especially when there are positive dividends by surprise and things like that, what could be an element of confusion.
Now, this is a very complicated indicator because in addition to volatility, it measures the change in the price from a trend point of view, and that is why it is an indicator that is included in the “trends”.
That is, if we have a large upward movement in an asset, with strong increases for many days, we will have an increasing Standard Deviation, because these prices will be far from the average n of the period we analyze.
This is the reason why we can have high standard deviations even in bull markets, which adds a lot of confusion to the indicator.
The normal thing, as I said before, is that such increases in volatility come in big bearish movements, but that may not be the case.
Examples of the Standard Deviation in the Stock Market
I’ll explain a possible way to use this indicator as a complement to others or even by itself, but yes, applying your own trading metrics.
For example, let’s imagine that we have a considerable bear market, as in the DAX 30 in 2011, with a very strong fall in the summer months.
As expected, we have a fairly strong increase in the Typical Deviation.
Well, we see how the value of the same goes up from 200 to 800, indicating that the changes in price, volatility and trend are being very strong, and if we look at the price we see that the price is going down in this case.
Verdict: bear market.
When the value “goes out of the chart” as in this case, we can foresee that the price will return to more normal values in the future.
For example, when the price is in the 800 we decided that we will start making purchases when the indicator falls below 400, which could indicate a possible market recovery.
In that case, fortunately for the Stock Exchange and economy, the bear market stopped there and later recovered.
Buying when the indicator fell below 400 could have resulted in a good long-term investment operation, and also trading, although depending on the stops used and even the strategy.
This example, although not much is given, can serve to give us an idea of the type of use we can make of this indicator, and as we suspect, we would do well to use qualitative trading techniques, not just quantitative ones. That is, techniques based on our knowledge of the market and that will be ours, that is, unique.
Another example of Standard Deviation applied to stocks
So we can see how subjective this indicator is, let’s see an example with Apple.
A few years ago Apple had a great upward movement that caused its Standard Deviation to go off from 2 to 12.
Here we have one of those confusing movements with which we do not really know what to do.
However, later movements clarify things for us.
Then this deviation was reassured and went to 3 euros, when the market quoted in a more “quiet” near maximums.
When we see that the deviation goes down in such a situation, what we could expect is a future increase in a major correction – remember that many corrections come after exaggerated bullish movements like the one in the case.
In this case we would be close to 3 and we would wait for the deviation to go to 5, for example.
That increase in deviation could be giving us an indication of a possible correction – I say possible because remember that this is speculation and nothing is certain.
And so it was: the price fell sharply in the following months with a drop of almost 50%.
We could have chosen to go down at that time, or simply wait for the deviation to settle down to 5 below, at which point we would have started buying.
This is a less clear example, but it also helps us how we can apply different ways to perform trading or investment operations using this very subjective indicator.
Although it should be noted that in recent examples I have used a period of 100 days, and here is the other issue that adds complexity to the issue.
What period to use for this indicator?
As always, everything will depend on the trader and the system he wants to apply.
There is no magic number, and different periods can work for different traders.
Does it work with Day Trading?
Honestly, I do not recommend you use this indicator for day trading because you will not be able to take it out of it.
The explosions in value that you are going to have are going to occur on a daily basis, but in the terrain of intraday we will not be able to discern if it is bullish or bearish movements and what is worse, we cannot really know what to do, taking into account of the random nature of the short term.
In that case it is better to use other indicators.
Greetings and good trading