Standard Deviation

Standard Deviation, a statistical concept, provides a reliable measure of volatility.

Overview

Standard Deviation is used as a component of many indicators in market analysis. In most cases, a high standard deviation implies high volatility and a low standard deviation implies low volatility. Basically it's a measure of variability, or how much the price varies from its moving average.

Here's a quick statistical refresher

Standard Deviation is a basic statistical concept. Consider a group of students taking an exam. You'll typically find that some score very high and some score very low, but most scores tend to cluster around the average. If you plot the results on a chart, you typically see the bell curve you may remember from high school (even though we don't like to remember where we were on the bell curve!). This is also referred to as the normal distribution curve.

Now, back to business…

You can also plot Standard Deviation for security prices. SD describes how prices are spread around an average (mean) value. The mean is the intermediate value between the extremes.

One month or twenty working days is the usual period used.

Interpretation

Major tops are typically accompanied by high volatility during the blow-off phase of a market, as investors become more and more nervous and ready to take profits. Major bottoms are usually calmer, with low volatility, as the hopes for quick profits have faded.

The smaller the difference between closing prices and the mean price, the lower the SD and the lower the volatility
The larger the difference between the closing prices and the average price, the higher the SD and volatility.

Standard deviation is useful for investing in stock options, because it provides a measure of volatility.

The higher the volatility for a particular stock, the higher the option premiums
The lower the volatility is for a particular stock, the lower the option premiums

Further information

Also see Average True Range, another volatility indicator.