How to Trade Forex with Standard Deviations
The standard deviation simplifies large amounts of historical data into a single value that summarizes how much a market tends to move, and it can create the foundation of a trading strategy by helping to not only identify a potential opportunity but also set prices to open and close a trade.
What is a Standard Deviation?
Theoretically, a standard deviation measures the variance of a dataset by producing a range that incorporates 68.3% of its values; more practically, standard deviations give a quick, digestible synopsis of how an event is likely to play out using past data the event has produced.
For example, if the standard deviation of daily net changes in EURUSD is 0.0060, the market has closed inside a range of -0.0060 to +0.0060 (on a daily net change basis) approximately 68% of the time.
Identifying a Trade Opportunity
Traders can use a market’s standard deviation to create a baseline for movement and then identify potential opportunities in markets whose current net changes are outside that preconceived norm.
Contrarians might view a market that has risen past the upside of its standard deviation range as a potential selling opportunity; whereas they might view a market that has fallen through the downside of the range as a potential buying opportunity. Trend followers tend to take the opposite approach by buying markets exceeding +1 standard deviation and selling those down -1 standard deviation.
Entering a Trade
Deciding on a price to enter a trade at can depend on how aggressive the strategy is intended to be:
• Low – Enter at -1.5 and +1.5 standard deviation
• Moderate – Enter at -1.0 and +1.0 standard deviation
• High – Enter at -0.5 and +0.5 standard deviation
For example, a moderately aggressive day trader might enter a new trade in EURUSD when its daily net change is showing either -0.0060 or +0.0060 and then either manage for profit (loss) at -0.0030 or +0.0030 or loss (profit) at -0.0090 or +0.0090.
Standard Deviations and the Law of Large Numbers
Using standard deviations to create expectations and set management mechanics for a new position can be the difference between taking profits at a practical time and letting a trade run to potentially large losses. Not to mention that taking small P/L swings per position teemed with trading more often can reduce short-term risks on the way to realizing long-term goals.
Standard Deviations of Major Forex Pairs
Standard Deviation calculated using 66 trading days of daily close data from June 10, 2022 to August 25, 2022 (Source: IG Trading Platform Standard Deviation Indicator)
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