The standard deviation indicator itself is a quantitative measure of variability or deviation around the mean. Deviation is the actual value minus the average value. When standard deviation gets higher, this means that variance/variability is increasing. When the standard deviation becomes lower, this means that the variance/variability decreases. Thus, the indicator is used to determine gravity or, in other words, the strength of an existing trend.
What is the standard deviation indicator?
This indicator is usually used in combination with other technical indicators, for example, Bollinger bands. Thus, when calculating the Bollinger Bands, the standard deviation value is added to its moving average.
Sometimes a particular trading instrument can be very active or, on the contrary, not be active at all. All this is reflected in the standard deviation indicator values. When the value is low, it indicates that the instrument is inactive and ranging whereas a high value can indicate a strong trend.
Trend traders do not usually enter the market when the standard deviation indicator is flat. Instead, they would pay attention to the market when the indicator starts rising in anticipation of a forming trend
Those who are using range trading strategy may consider looking for low values in the standard deviation indicator. This can help them to identify less volatile market conditions that present reversal trade opportunities.
How is standard deviation calculated?
Below is the formula to calculate the standard deviation:
StdDev (i) = SQRT (AMOUNT (j = i – N, i) / N)
AMOUNT (j = i – N, i) = SUM ((ApPRICE (j) – MA (ApPRICE (i), N, i)) A 2)
StdDev (i) : Standard deviation of the current candle
SQRT : Square Root
AMOUNT (j = i – N, i) : Sum of squares from j = i – N to i N : Smoothing period
ApPRICE (j) : Applicable price of the j-th candle
MA (ApPRICE (i), N, i) : Any moving average of the current bar with period N
ApPRICE (i) : Applicable price of the current bar
How to use the standard deviation indicator?
Changes in market volatility will be reflected in the standard deviation indicator. The stronger the current trend, the higher the value of the indicator. The weaker the trend, the lower the value. Thus, this indicator is primarily used to spot trending and ranging markets.
The standard deviation on the 15-minute chart of the EUR/USD currency pair is shown in the chart above with default parameters and a simple moving average with a period of 20. You can see how the indicator responds to changes in price movement.
When the market is inactive, the indicator is at the bottom, showing lateral movement. At the time of market activity, the indicator rises regardless of whether the primary trend is bullish or bearish. An increase in market activity is noted as soon as the indicator rises – this indicates a multiple opening of positions by other market participants.
Whilst the standard deviation indicator can show how strong or weak a trend is, it does not tell you in which direction the market is moving. Therefore, the indicator works best with additional market analysis.
Standard deviation trading strategy
The standard deviation is best used with other trading indicators, such as the Moving Averages Convergence and Divergence (MACD) indicator. The MACD can confirm the trend, and also show when the trend changes the direction, and this, in turn, when combined with the standard deviation, can give more reliable entry signals.
When the MACD signal line and the histogram are below the zero lines, the indicator portends a bearish trend and the ability to start opening short positions. Look at the chart below:
When the MACD signal line and the histogram are above the zero lines, the indicator portends a bullish trend, in this case, you can look for a moment to open long positions. Look at the example below:
It should be kept in mind that when the standard deviation shows a strong rise, this can mean two things: the resumption of the present dominant trend or the upcoming change (reversal) of the dominant trend.
Standard deviation conclusion
The standard deviation indicator can useful to filter trading signals according to trending or ranging markets. Usually, the lower the standard deviation value, the less volatile the market is. An increase in the value of the standard deviation can identify an increase in market activity.
The methods of implementing the standard deviation indicator into a trading strategy that are outlined within this article are just ideas. I would always ensure that I have good money management, trading discipline and a trading plan when using any forex strategy.
Furthermore, I would combine multiple technical analysis, fundamental analysis, price action analysis and sentiment analysis to filter all entries. You should trade forex in a way that suits your own individual style, needs and goals.
If you would like to practice trading with the standard deviation indicator, you can open an account with a forex broker and download a trading platform. If you are looking for a forex broker, you may wish to view my best forex brokers for some inspiration.