Standard deviation measures volatility or dispersion around an average. Dispersion is the difference between the actual value and the average value. The bigger this dispersion or variability is, the higher the standard deviation. The smaller this dispersion or variability is, the lower the standard deviation. Traders can use the standard deviation to measure expected risk and get to the nuts and bolts of certain price movements.
Standard deviation values are dependent on the price of the stock in question. Securities with high prices, will have higher standard deviation values than stocks with low prices. These higher values are not a reflection of higher volatility, but rather a reflection of the actual price.
The value of the standard deviation can be used to set expectations or to estimate the importance of a move. This is assuming that price changes are typically distributed with a classic bell curve.
Although price changes for stocks are not normally typically distributed, traders & investors can still use normal distribution guidelines to determine the significance of a price movement.
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Standard Deviation is calculated using the following formula:
Average (mean) price for a # of periods = Add closing price / # of periods
(Each period close - average price = deviation) squared
Square root of (sum of squared deviations / # of periods) = Standard Deviation
In a normal distribution, 68% of the points are usually within one standard deviation. 95% of the points are usually within two standard deviations. 99.7% of the points fall within three standard deviations. Using these guidelines, traders can estimate the significance of a price movement. A greater move than one standard deviation shows above average strength or weakness, depending on what direction of the move is made.
As with all other indicators, don't just rely on the defaults, adjust your indicators to suit the stock you are looking at and your trading style.
Typically shorter look backs (lower #'s on your indicators) give you quicker signals which is good for aggressive traders, while longer look backs (higher #'s on your indicators) give slower but more reliable signals for traders who are more conservative.
As we always say: "Don't use your hard earned cash to find out what kind of trader you are, use a virtual account for that."
Links for free virtual trading sites can be found on our Resources page: