In terms of capitalization, the world’s largest market is the foreign exchange marketplace, or “forex.” With more than $5 trillion in daily traded volumes, the forex 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.
The 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 in this context and how it can augment your currency trading strategy.
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 widely used in statistics to measure the variance of a dataset from its mean (or average) 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—but not limited to—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 value. This is done by executing the following basic tasks:
- Defining a series of closing prices according to time or other periodicity
- Calculating a mean value for the defined dataset
- Measuring the dispersion, or difference between the closing price and the mean value
Due to the complexity of this technique, manually calculating deviation in forex in a live trading environment is most likely 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.
Note: Any trades are educational examples only. They don’t include commissions and fees.
How do I apply deviation to my forex trading?
Now that we’ve covered the basics of forex deviation levels, let’s turn to how to apply the concept to your ultimate market approach. Although the mathematics behind standard deviation can be a bit convoluted, applying the concept itself is relatively 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 risks 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 of using this measurement to determine deviation in forex is that it’s an intuitive tool. Once you identify the presence of high or low deviation, you can tailor your trading strategy accordingly.
Here are a few common ways that traders leverage 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 versus reward trade setups.
- Low deviation situation: If 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.
Get 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. Refining such skills is a matter of practice and resourcefulness. You can leverage these expert strategies from StoneX to learn how to think like a successful technical trader.
