10 ideas for using Standard Deviation

To start with, what is the standard deviation? This statistical measure, which can be computed as the square root of the variance, is a statistic that expresses the dispersion of a dataset in relation to its mean. Put simply, the standard deviation is a kind of volatility indicator that highlights and evaluates volatile periods. It also modifies other technical indicators’ settings to help the system respond faster to signals during volatility spikes.

By measuring the difference of every data point from the mean, the square root of the variance is used to calculate standard deviation. A higher deviation exists within the data set when the data points deviate from the mean. Therefore, the more dispersed the data, the higher the standard deviation.

What does the standard deviation mean?

The standard deviation is a statistical measure used in finance to assess the past volatility of the annual rate of return on an investment.

More variance exists between any given price and the mean when it comes to securities, which creates a wider range of prices. For example, a high standard deviation is often associated with volatile stocks. In contrast, stable blue-chip stocks tend to have a lower standard deviation.

What does standard deviation indicate?

In statistics, the standard deviation indicator is used to quantify market volatility. It also defines the variability or dispersion of a data set around the average. It describes the price volatility in relation to a moving average (usually computed at 20 days) in analyse technique. The more unpredictable or volatile the market is, the market is, the higher the standard deviation.

Conversely, a market is more stable and steady when standard deviation is lower. In other words, price bars are closer to the moving average. It is widely known, nevertheless, that market dynamics are typified by a cyclical pattern of stable intervals and activity peaks.

How to calculate standard deviation?

When comparing data points to a population’s collective mean, one can calculate the standard deviation by taking the square root of the generated value. The formula is:

[σ (x) = √V (x)]

Conversely, the squared value obtained by subtracting the mean (x) from each value in the data set and dividing the result by the total number of values in the set can be used to compute the trading variance.

To calculate, you will need to follow the steps below:

1. Determine each data point’s mean. To find the mean, add up each data point and divide it by the total number of data points.
2. Determine the variance for every single data point. Each data point’s variance is determined by deducting the mean from the data point’s value.
3. Square each data point’s variance (from Step 2).
4. Squared variance values added together (from Step 3).
5. The number of data points in the data set less one is equal to the sum of squared variance values (from Step 4).
6. Determine the square root of the quotient (from step 5).

Let’s take Apple’s stock’s performance from 2016 to 2020 as an example.

In the years 2016–2020, the returns on Apple Inc. shares were 10.03%, 46.11%, -6.79%, 86.16%, and 6.05%. Over the course of five year period, the average yield (m) was 28.31%.

The return value is as follows: -18.28% in 2016, 17.8% in 2017, -35.1% in 2018, 57.85% in 2019, and -22.26% in 2020 for each year minus the mean. The numbers can then be squared to get 334.15, 316.84, 1232.01, 3346.62, and 503.07.

After adding and dividing the squared values by four, the variance comes out to 1433.17. After taking the variance’s square root, we are left with a standard deviation of 37.35%.

How to incorporate standard deviation into your trading plan

When performing risk management, standard deviation is used in a number of trading indicators to calculate risk versus return. It can be used on an index, a single asset, or the whole market. This statistical measure can be used to quantify the historical volatility of an investment or trade when applied specifically to the rate of return.

Deviation can also be used to gauge the present price action in a market. Market tops with low volatility, on the other hand, might point to a more experienced bull market. For instance, market tops with growing volatility might point to unsure traders.

Conversely, low standard deviation suggests traders may be uninterested in the current market, while high standard deviation indicates panicked sell-offs at market bottoms.

Trading strategies

The standard deviation is an essential instrument for determining market volatility. It is crucial for evaluating risk and guiding trading choices. Although it can be used on its own to measure volatility, it also complements other indicators for a thorough market analysis. You can incorporate standard deviation into your trading strategies in the following ways:

• Risk Assessment: A crucial component of risk assessment is volatility, which is assessed with the help of standard deviation. Commodities and other assets with higher standard deviations are often associated with larger price swings and possible losses. However, more evenly distributed stock indices tend to show lower deviation.

• Diversification: A diversified portfolio helps reduce risk by investing in a variety of assets. Volatility aids this strategy by allowing investors to compare the volatility of various assets. It ensures a balanced mix that mitigates the effects of highly volatile assets.

• Volatility Trading: Regardless of the direction of the market, traders who specialize in volatility trading profit from price swings. Is helpful when evaluating anticipated price movements, especially when trading options and derivatives.

• Choosing Stop Loss and Take Profit Orders: To determine suitable stop loss and take profit levels based on an asset’s volatility, use volatility. Wider ranges might be required for higher standard deviations, whereas tighter ranges might be justified for lower deviations.

• Bollinger Bands: Bollinger Bands, a technical analysis indicator, can help predict trends based on price momentum when volatility is added. These bands, which are made up of a moving average and lines drawn at particular standard deviations above and below, aid in spotting possible breakouts and trend reversals.

• Mean Reversion: The statistical measure helps to pinpoint instances in which the price of an asset deviates considerably from its historical mean. This is in line with mean reversion strategies, which predict that prices will eventually return to their average.

• Finding Flat Markets: Volatility can provide insight into the elements that lead to flat markets. While flat markets are frequently accompanied by low trading volume, high volume markets may indicate  an impending breakout and offer trading opportunities.

You can improve your ability to manage market volatility and make wise trading decisions by adding standard deviation to your toolkit.

Advantages of standard deviation

A popular way to quantify dispersion is with standard deviation. Compared to other statistical computations of data deviation, volatility is likely more familiar to analysts. This is why actuaries and investors alike frequently use volatility in a range of contexts.

The standard deviation includes every observation. The analysis includes every data point. Other deviation metrics, like range, only account for the farthest points and ignore the points in between. Because of this, the standard deviation is frequently regarded as a measurement that is more reliable and accurate than other observations.

A particular combined standard deviation formula can be used to combine standard deviations of two data sets. For other statistics-related dispersion observation measurements, there are no comparable formulas. Furthermore, in contrast to other observational methods, volatility can be applied to additional algebraic calculations.

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