Standard deviation is a statistical measure of volatility. As currency market is highly volatile than others, the Forex traders should analyze the volatility in the currency movement. The only measure of volatility is derived by the standard deviation.
Standard Deviation can also be used with other oscillators.
There is only one parameter in calculation of standard deviation which is the number of periods. By default it comes as 20-periods. Forex Trader can make shift of 20 to 10 for intraday to 50 for positional call.
There is also option to use SMA, EMA ,smoothed and Linear weight-age. It is recommended to apply EMA for Intraday position as it more concentrates upon current price movement.
Standard Deviation Calculation:
It is derived by calculating n-period simple moving average of the currency price (i.e., the closing price) summing the squares of the difference between currency closing price and its moving average over each of the preceding n-time periods, dividing this sum by n, and then calculate the square root of this result.
= √∑(Close price- n-period SMA/EMA of close price)2/n
n = number of time periods
SMA = Simple moving average.
EMA = Exponential Moving Average.
Screen short of Standard Deviation in Meta-trader:
One needs to go on Navigator to oscillator and select standard Deviation. In above Diagram period by default is showing 10 Days and Methodology is Simple.
Standard Deviation Interpretation:
High standard deviation values occur when the closing price and average closing price differ considerably. Similarly low standard deviation values occur when prices are stable.
Major tops are accompanied with high volatility as investor struggle with both euphoria and fear. Thus sell signal is indicated when standard deviation is at its peak, indicating the market is rapidly rising due to emotions and will fall in the future. Thus the Forex Trader should avoid long position in currency and look forward to trade in opposite direction.
Major bottoms are expected to be calmer as investors have few expectation of profit. Thus a buy signal is indicated as the standard deviation is at its low indicating lull in the volatility. Thus Forex trader should take fresh long position in the currency.
In Fig. the tops and bottoms of standard deviation are indicating buy/sell signal. A Forex trader can eliminate the risk of higher volatility while taking help of standard deviation. A panic sell off in the market create a oversell zone and Forex traders should quick enough to judge these signals to trade in the opposite direction. Though this shows more of a contrarian view point of the trader. A Forex trader should judge whether the sudden ups and down are mere the emotion led movements or they are really been the some technical factors influencing the currency price movement.