Last Updated on 09/05/2024 by Ndanileka
Traders rely on analyzing volatility to understand the price action behind price movements. A common tool used for this analysis is the standard deviation. While this approach offers a basic understanding of volatility, it paints a limited picture. Imagine standard deviation as a single snapshot – it tells you how much a stock’s price return is likely to deviate from its mean over a specific period, but it doesn’t reveal the distribution of those deviations.
Standard Deviation Analysis builds upon the Sigma spike and presents standard deviation values in a visual form. This is achieved by plotting bands above and below the mean of price returns. The width of these bands represents the standard deviation and indicates the expected range of price returns (usually around 68%) that are likely to occur within the bands.
This method offers a more comprehensive understanding of volatility, showing the distribution of price returns provides context and examining how price returns group together within the bands, enables you to identify periods of consolidation where the bands become tighter, coupled with price returns that do not reach the bands, or periods of erratic price swings where price returns extend beyond the band. This reveals the “nature of the price action” that drives volatility, providing context to the current standard deviation value.
A Look at Different Scenarios
Band Expansion: When the bands widen, it signifies increasing volatility. Price returns will likely scatter further from the average price, indicating potential breakout opportunities or heightened risk depending on your trading strategy. 
Stable Price: If the bands remain relatively flat with a few price spikes beyond the bands, it could indicate a period of volatility contraction or a ranging market that may lead to a breakout. 
Band Contraction: Narrowing bands suggest decreasing volatility. Price returns tend to cluster closer to the average price, potentially signaling consolidation phases or lower trading volume.
How to Implement into a Trading Strategy
Volatility Analysis can be a powerful addition to your trading toolbox and here’s how you can integrate it into your watchlist workflow:
- Build a Scan Based on Standard Deviation: Create a scan using standard deviation as a criterion. This scan can identify stocks with volatility levels that fall within your preferred range, helping you build a targeted watchlist.
- Refine the Watchlist: Once you have your initial watchlist populated by the scan, use the Standard Deviation Analysis tool. Apply this tool to each stock on the watchlist to analyze the distribution of price returns within the bands.
- Create a Shortlist: Identify stocks that exhibit behavior aligning with your trading strategy.
This could be anything from identifying potential breakouts (consolidation) to pinpointing an outlier in the price returns.
The overall approach simplifies the process of finding “trading setups”.
Firstly, a standard deviation scan identifies potential stocks that fall within your preferred volatility range. Secondly, it lets you focus on the most promising stocks identified during the initial scan.
Then, by analyzing how price returns interact with the bands for each stock, you gain insights into the reasons behind the volatility. This deeper understanding empowers you to build a more focused shortlist with greater confidence.
Happy Trading!
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