How to use the standard deviation for profitable investments

The price of a stock fluctuates up and down depending on the company or economic news. It is difficult to determine with great precision the probable long-term direction of a share’s price. However, you can make any possible profitable investment decision in a short-term time frame by using the standard deviation. The standard deviation displayed as Sigma is a measure of the variability or spread of a data point from the mean or average of a data set or time series. A high value denotes more variance from the mean. Conversely, a low number indicates how close a data point is to the mean or expected value.

If you assume that a stock’s closing prices are random and follow a normal distribution, then you can use the stock’s price fluctuations around its mean to make some profitable trading decisions. The standard deviation, which is expressed as the same unit as the data set, can project the probability of a stock price movement around its mean price. For example, if the mean closing price of Stock A is $25 and its sigma is $1, then one sigma indicates a 68 percent chance that the next closing price will be between $24 and $26. While two sigma projects with a 95 percent chance that the next closing price will be $23 to $27. Finally, three sigma establishes with a 99 percent probability that the next closing price may be between $22 and $28.

You can use this information about a stock’s closing price in three different techniques to make some potentially profitable investment decisions; buy a stock to initiate a new long position, sell your holding position to exit a profitable investment, and protect your position by placing a stop-loss order.

Consider the example above, stock A with an average daily closing price of $25 in the last year. When the stock price sells two sigmas below the mid price at $23, you can initiate a buy order and buy the stock. To protect your position against a possible loss due to a downside move, you can place a stop loss order to sell your stock at $22, which is three standard deviations from the mean. Consequently, you can place a sell order to exit part of your long position at your first profit target, which is $25, the average price. You can sell all of your holdings at the $27 or even $28 price levels, which are two and three sigma respectively.

It should be noted that the closing price of shares rises and falls daily; you should monitor its daily movement and adjust your stop loss or profit target accordingly.

If you have a high risk tolerance for aggressive trading, you can use the standard deviation method to short a stock. By shorting a stock, you hope to buy the stock back at a lower price for a profit. In other words, if a stock is trending down, look to short the price when it rises to unusual price levels, such as two or three standard deviations above its mean. If you short a stock at a price level of two standard deviations, you can place your stop loss order at the price corresponding to three standard deviations. Consequently, your target earnings may be at the average price level or one or two standard deviations below your mean.

Many Internet financial websites that provide live data and charts for stocks allow you to use different technical indicators. Bollinger Bands is a technical indicator developed based on the concept of standard deviation. However, it uses simple moving averages to replace the mean value. Consequently, you can adjust the outer bands around the value of the moving averages to one, two or three standard deviations. Conversely, if you want to use all three standard deviations, you can insert the same indicator on your stock price chart three times and change the bands to values ​​of one, two, and three standard deviations.

To augment your trading decisions for better accuracy and higher probability of winning when using the standard deviation method, you can use another tool like 50 or 200 day moving averages. For example, if the stock price is above its 50-day moving averages, you can try to buy the stock two standard deviations below its daily mean price. However, if the stock’s closing price falls below the 50-day moving averages, it may indicate the start of a reverse trend. Consequently, you should be very careful when buying stocks as they may continue to sell off and fall further. Conversely, if you decide to short a stock, you should use the 50-day moving averages, as an example, to confirm the direction of the downtrend.

It is much easier to use any spreadsheet program to calculate the mean price and standard deviation of a time series than manually. Enter the daily prices of a stock from the previous year and use the program’s formulas to calculate its average daily price and its standard deviation. However, these price levels may change based on the new daily closing prices of your shares. However, you can add the new closing prices each day to your Excel spreadsheet and get the new values ​​for the mean and standard deviation. By doing so, it creates a dynamic stream of price levels that help you monitor and invest in stocks for better profits.

You can decide to make your trade more or less active by adjusting your time frame. For example, if you decide to change (short term) or day trade, then you can use different intraday periods like 30 or 100 minutes. Using 100-minute closing prices as an example, you can apply the above method to trade your favorite stocks more frequently.