For active currency traders, market volatility presents a vast array of opportunities and challenges. Fluctuations in the exchange rates of forex pairs can occur rapidly and seemingly out of nowhere. If not consistently put into a manageable context, turbulent price action can prove detrimental to a trader's chances of sustaining long-run profitability.
Standard deviation is one mechanism used by forex market participants to identify normal and abnormal moves in pricing. When used as part of a comprehensive plan, it can be invaluable to the crafting of informed trade-related decisions.
What Is Standard Deviation?
Standard deviation is a statistical device used to measure the distance between a data point and its mean value at a specific time. Introduced in 1894 by British mathematician Karl Pearson, standard deviation quantifies variability or dispersion in numerical terms. It is frequently implemented in many disciplines including science, technology, and finance.
The following is the basic definition of standard deviation and its components:
- Standard deviation is the square root of a value's variance. It is symbolised by the greek letter sigma.
- Variance is the average of all squared differences from a predefined mean. Variance is symbolised by the greek letter sigma squared.
- An arithmetic mean is found by adding up all individual values of a data set and then dividing by the total number of instances. In essence, the mean is a simple average and is symbolised by the greek letter mu.
To find standard deviation, users can look to this formula for guidance.
The actual derivation of standard deviation may vary and depends on the application. Sample data sets are often grouped according to assorted parameters, with the relative mean value being either actual or assumed.
One of the most beneficial aspects of standard deviation is that interpreting the data is intuitive. Large deviation values represent a high degree of variability, while small deviations represent low variability. This information is especially useful in quantifying a data set's dispersion, or in forex, pricing volatility.
Applications To Forex Trading
As in stocks, bonds, futures, and options pricing, the concept of volatility is one integral to quantifying opportunity and risk. Market structure depends greatly upon the relative movements of price, be it in a trending, range-bound, or compressed environment. Having a technical tool such as standard deviation at one's disposal can help with making this determination in an efficient manner.
In forex trading, the dispersion of periodic exchange rates may be interpreted in three basic fashions: low, normal, and high. Each designation represents an inherent level of pricing volatility facing a currency or currency pairing. When a standard deviation value is calculated, you can then make strategic considerations.
Below are the primary ways of interpreting standard deviation as applied to the forex:
- Low: Low levels of deviation indicate that price action is condensed and the market is in relative consolidation. In response, traders may choose to adopt rotational trading strategies, such as a reversion-to-the-mean approach. When adhering to this type of methodology, opposing positions are taken from the vicinity of a periodic extreme. Profitability is then sought from price returning to its relative average or mean value.
- Normal: Normal deviation suggests that a market is behaving as expected, exclusive of any undue turbulence. A broad array of strategies may be warranted, including scalping, range trading, and pivot point methodologies.
- High: High standard deviation readings suggest that pricing volatility is at extreme levels. This is accompanied by wide periodic ranges, robust price action, and heavy participation. Currency pairs that exhibit high volatility present traders with a quandry, as the enhanced price action increases both assumed risk and potential reward. Trend following and reversal strategies often become attractive due to the possibility of realising extraordinary gains.
Each of the above rankings of deviation presents a collection of unique challenges and benefits. Ultimately, it is up to the individual to decide which levels of pricing volatility are viable for trade given available resources and market-related goals.
An important distinction to make regarding standard deviation is that it is designed for comparison. Implementing the value in isolation is not especially useful, unless operating within a set of predefined guidelines. When determining whether a currency or currency pair is exhibiting low, normal, or high volatility, it is necessary to either calculate the figure for more than one data set, or to reference an accepted benchmark.
Implementing Standard Deviation
Addressing the exchange rate volatilities of currency pairs as they evolve is a key element of active forex trading. Being able to identify when markets are trending or consolidating is an important skill, and one that is aided greatly by the standard deviation indicator.
Forex software trading suites typically feature standard deviation in one or more forms via public domain indicators. Below are two commonly used by forex traders:
- Bollinger Bands: Created by John Bollinger in the 1980s, Bollinger bands (BBs) are a technical indicator that quantify pricing volatility through the production of upper and lower "bands." Standard deviation is a key input in this calculation, as it determines the width of the bands.
- STDEV: STDEV is the basic application of the standard deviation statistic upon exchange rate pricing. It is derived by first taking a sample set of price points, then calculating their mean, variance, and deviation. Typically, STDEV is represented as a graphing overlay for easy reference. It provides the user with a visual representation of price's dispersion from an established mean value.
Like the vast majority of indicators, those based on standard deviation are best used in concert with other tools. Technical devices such as Fibonacci retracements, momentum oscillators, and time price offering charts may prove complimentary.
Standard deviation is widely accepted by active traders as a powerful technical indicator. It is easily interpreted in live market conditions and may be automatically applied via the functionality of most software trading platforms. Although manually calculating deviation values is time consuming, modern technology has eliminated the need for any tedious mathematical long-hand. As a result, technical traders from all corners of the forex market favour tools such as Bollinger bands and STDEV.
FXCM Research Team
FXCM Research Team consists of a number of FXCM's Market and Product Specialists.
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