In this article we will explore standard deviation: a mathematical and statistical tool very useful for all those who wish to advance their knowledge of trading and the more technical aspects of finance. Remember that you can try this tool on this totally free platform.
In finance and trading, experts use a graphical function called a standard deviation, a gap used to indicate the variability of a financial asset and its returns. In practice, this graphic function represents a measure of the volatility of the activity, and also of its implicit degree of risk. It is also used by the Capital Asset Pricing Model, to measure risk and univocally determine a market price.
Before going into the technicalities of standard deviation, let’s first define some concepts to better understand it.
What is Volatility?
When we mention volatility in trading and in finance we mean a measure of the correlation between the change in yield and the reference market.
To put it more simply, having a certain type of market as a reference, volatility tells us how the performance of a security (e.g., a stock), with respect to that market, behaves. One of the tools to measure the volatility of a financial asset is standard deviation, which helps us understand how risky the activity is. The concept of risk should already be known to you, so we won’t discuss it here.
Let us now analyse this from a strictly technical point of view, for the benefit of the more mathematically passionate trader. The standard deviation represents an index of dispersion of the experimental measures, that is, an estimation of the variability of a random variable (e.g., the market price). In calculating the standard deviation, the dispersion around an expected value or its estimate is considered. In the statistical field, when it comes to standard deviation, it is also referred to as “precision”.
Standard Deviation in Trading
Returning to a simpler language, you can therefore define standard deviation as a certain interval in which the data moves around a given “standard”. If we consider the price of a share of €50, we could have a standard deviation of €20 if it moves as “usual” or “in any given period” between 30 and 70. The standard change tells us that it can go 20 above or 20 below 50 euro.
In the always excellent free platform of Plus500 we clicked on the f(x) button and set the “Standard Deviation” indicator. Once set, we have enlarged the window to show you the chart in reference to 1 week and 1 day.
Here is the main screen of the Plus500 platform for online trading. We have selected Facebook stock for this example.
Here is how we set the “standard deviation” indicator.
In this screenshot we take 1 week’s deviation as reference (from the drop down menu)
In this next screenshot, we reference the day (from the drop-down menu, we choose “1 day”)
Go to lesson 18 – Fibonacci in trading with CFD