Understanding the concept of standard deviation of price is essential if you want to win at forex trading yet very few traders have even heard of it, let alone understand it. If you understand it and its significance you can get a head start on the vast losing major and enjoy greater forex profits and we will look at standard deviation in more detail in this article.
Standard Deviation Defined
Standard deviation of price is a statistical term that gives an indication of the volatility of price in a market and it can be applied to any investment market – shares, bonds, commodities and of course forex.
Standard deviation simply gives a view of how broadly values (closing prices) are dispersed from the average price. Dispersion is defined as 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 of the market studied will be.
Of course if standard deviation is high, this indicates the volatility of the price in the market studied.
On the other hand, if the closing prices are close and do not fluctuate much from the average mean price, standard deviation is less and the markets volatility is considered less as well.
How Standard Deviation Calculated
To calculate standard deviation is simple:
All, you do is take the square root of the variance, the average of the squared deviations from the mean.
Do not worry if you do not understand the calculation above, you do not need to know how an internal combustion engine works, to drive a car.
There are visual indicators to help you which we will return to in a moment.
High Standard Deviation values occur when prices are highly volatile and low Standard Deviation values occurs, when prices are fluctuating in a narrow range or more stable.
How to Use Standard Deviation for Profits
When short term price spikes occurs and prices become highly volatile, this is typically a reflection of human psychology, reflecting the emotions of greed and fear driving prices to far from fair value.
If you look at any forex chart you will see that all short term price spikes are temporary and prices quickly fall back to fair value.
Human psychology pushes prices too far and when sentiment peaks, prices fall and vice versa in a bear market.
This happens time and time again and will continue to happen, because human nature never changes. Humans will always push prices to far away from the fundamentals.
This is the equation that works in any free market and that includes forex here it is:
Supply and demand news + Investor Perception of = Price.
The Fundamentals news etc is NOT important – it's how investors perceive the supply and demand situation that is.
When a big price spike occurs you know it's not going to last and if you can sell or buy it at the right time you can make money – but you must time your trading signal correctly.
So how do you measure it?
In part two of this article we will look at this greater depth and how to use Bollinger bands in association with other timing tools, to hit the high profit turning points at the right time.
Standard deviation of price is a concept you must understand, if you want to be a successful forex trader; not only will it help you spot important market tops and bottoms, it will help you place stops correctly and determine profit targets.
We will look at all the above in relation to standard deviation in part 2 of this article series, for now you have an idea of what standard deviation is and why it's so important.