In terms of capitalization, the world’s largest market is the forex. With more than $5 trillion in daily traded volumes, the forex market offers participants a high degree of efficiency due to its robust depth and liquidity. For many traders, the forex is a premier avenue for the pursuit of almost any financial goal.
Forex and futures are very different financial instruments, but the ways in which they are traded are very similar. Although the underpinnings of each market are unique, the application of technical analytics remains relatively constant. Standard deviation is one of the more popular technical tools used in forex trading. So, what is the definition of deviation in forex? We’ll break down what standard deviation is and how it can augment your currency trading strategy.
Question #1: What Is the Definition of Deviation in Forex?
If you have any experience in the markets, then you know that a sudden spike in volatility can close out a soon-to-be profitable trade as a loss. That’s where standard deviation is most useful ― it establishes the inherent volatility of a currency pair before an order is ever placed.
Standard deviation is a term used in statistics to measure the variance of a dataset from its mean value. Essentially, the further a value falls in relation to its mean, the greater the standard deviation. This methodology is applied to many disciplines, including healthcare, academics, and population analysis.
When it comes to defining deviation in forex, it’s best thought of as being a volatility measurement. Traders use it to put current price action into context by establishing a periodic closing price’s relation to an average or mean value. This is done by executing these basic tasks:
- Defining series of closing prices according to time or other periodicity
- Calculating a mean value for the defined data set
- Measuring the dispersion, or difference between closing price and the mean value
Due to the complexity of calculating standard deviation, doing so manually in a live forex environment is a nonstarter. Fortunately for active traders, most software platforms feature a deviation tool that executes the derivations automatically — in real-time. Among the most popular are Bollinger Bands and the Standard Deviation Indicator.
Question #2: How Do I Apply Deviation To My Forex Trading?
Now that we have answered Question #1 —“what is the definition of deviation in forex?” — let’s turn to how to apply the concept to your approach to the market. Although the math behind standard deviation is a bit on the convoluted side, applying the study is straightforward. Once you’ve derived a single or set of deviation values, there are two basic interpretations of the data:
- High deviation: In the event that periodic closing prices are falling far away from an established mean, deviation is said to be “high.” This means that pricing volatility is extreme, and the periodic ranges are large. Both assumed risk and potential rewards are greater during periods of high deviation.
- Low deviation: Conversely, “low” deviation suggests that periodic closing prices reside near the established mean. Under this scenario, pricing volatility is limited, and a currency pair is in a consolidation phase. Low deviation often coincides with choppy price action, limited participation, and pending breakouts.
Perhaps the biggest advantage to using standard deviation is that it’s an intuitive tool. Once you determine the presence of high or low deviation, you can tailor a trading strategy accordingly. Here are a few common ways that traders use this information:
- High deviation situation: Currency pairs exhibiting extreme volatility are prime targets for both reversal and trend-following approaches. The wide periodic trading ranges provide ideal risk vs. reward trade setups.
- Low deviation situation: In the event volatility is muted, rotational trading strategies are often the best course of action. Breakout trading plans may also be suitable, although the risk of false breaks can limit performance.
Getting Started with Technical Analysis
In the modern marketplace, technical analysis is a popular means of crafting trading decisions. From market entry and exit to position management, a vast number of technical traders rely on the study of price action to secure market share.
If you’re new to technical analysis — or want to be able to answer questions like “what is the definition of deviation in forex?” — check out the online educational portal available at Daniels Trading. From indicators to expert insights, it’s a great place to build a rock-solid technical foundation for your trading strategies.