Standard deviation channels is a technical indicator widely used by traders for identifying volatility in a market. It is a popular tool for trading not only in stocks but also in currencies and other financial instruments. Essentially, it consists of an upper and lower band as well as a centerline which represents the average of the prices studied. Traders use standard deviation channels to identify overbought and oversold conditions in the market based on the distance from the bands to the centerline.
What is Standard Deviation?
Standard deviation is a statistical calculation that measures the amount of variation or dispersion of a set of data points from their average or mean. When plotted on a chart with the price data, the standard deviation represents a range of prices where a certain percentage of the data falls. Typically, standard deviation is calculated over a period of time and is used to identify the level of risk associated with a particular investment.
Construction of Standard Deviation Channels
The construction of standard deviation channels requires first calculating the mean or average of the prices being studied. This is then plotted as a horizontal line in the center of the chart. The upper and lower bands of the channel are then drawn equidistant from the centerline, with the distance between the bands equal to a multiple of the standard deviation away from the mean. The most common multiple used is two, which represents approximately 95% of the data within the range of the bands.
The upper band represents the price level at which the asset being studied is considered overbought, while the lower band represents the price level at which it is considered oversold. These levels can be used as buy and sell signals by traders, with the idea being to buy when the price is in oversold territory and sell when it is in overbought territory.
Using Standard Deviation Channels for Trading
When using standard deviation channels for trading, one of the most important considerations is the time period used. Shorter periods can help traders identify more precise trading signals, while longer periods can help identify longer-term trends.
One common trading strategy with standard deviation channels is to look for instances where the price breaks out of the channel. This can be a signal of a potential trend reversal or continuation, and traders may use this as a signal to enter or exit trades. Another common strategy is to look for instances where the price approaches the upper or lower bands, as this can indicate a potential reversal back toward the centerline.
Conclusion
Standard deviation channels are a useful tool for traders looking to identify volatility and potential trading opportunities in a market. While they are not infallible, they can help traders identify overbought and oversold conditions and potentially take advantage of price movements. By using this indicator in conjunction with other technical or fundamental analysis tools, traders can improve their chances of success in the markets.