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Let me start with a question. How many technical indicators you have heard of and how many you use in your trading and investment decisions? For most of us, the number is overwhelming. If you are serious trader then you must have tried quite a few of them in designing your strategy and needless to say some might have worked and others have not. If you are overloaded with indicators and want to cut short the noise, there is a simple and elegant statistical concept which can provide some key actionable insights about your anticipated trades. Hopefully you already know the concept of Standard Deviation, however here we will analyse the same with real life data. We will also provide some tools and plots which you can use to augment the accuracy of your trades. So let's find out how Standard Deviation helps in gauging the probability of an unexpected move in security price and how you can leverage this knowledge to spot and enter profitable trades. To begin with, here is a one line definition of Standard Deviation:
Standard deviation is a statistical measure of volatility, i.e. the amount the stock price fluctuates, without regard for direction.
Volatility is synonymous with risk, hence basically standard deviation quantifies risk. Let's plot the standard deviation of last one year price of all FnO stocks to visualize their distribution and identify stocks which are highly volatile, moderately volatile and mildly volatile.
Hope now it's not too difficult to identify the most volatile stocks (on the right) and the most stable stocks (on the left). Generally speaking, for the stocks at the right, the option premiums would be high plus the up or down movement would be more fierce. If you are new to trading, you should not dabble in these stocks unless you have gained some experience with respect to risk management (risk appetite, position sizing, stop loss).
For further deep dive into the price behavior of a particular stock of interest, you can use the following tool which basically will output:
- A line plot of daily price, mean price and Standard Deviation (SD) of stock prices for last one year
- A box plot of daily stock prices for last one year
- A histogram (normal distribution plot) of stock price of last one year
Standard Deviation Plot, Box Plot, Histogram of Last One Year Prices
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If you have followed along well then the next obvious question which will pop up in your mind is which are the stocks trading above or below their +- 2 SD price. As an answer to such commonsense questions, here is the list of stocks trading in various ranges of their Standard Deviation and Mean Price:
Based on your risk appetite, these stocks could provide good trading opportunities. For example, if your view on a particular stock is bearish and simultaneously you notice that the same stock is trading above its 2 SD price, then you can buy ITM puts or write OTM calls (do put proper stop losses in place). The rationale is, trading above 2 SD price supplements your bearish view as statistically speaking, 95% of the observations should fall within the 2 SD range. Having said that, do not follow this strategy blindly and do your own analysis before opening the trade. The key here is - your bearish view of the stock is right else the strategy will fail. Needless to say that this is just an example and you can definitely think of more creative FnO strategies around this data. So please go ahead and flex your neurons :-). Just in case your creativity is getting constrained due to lack of data, here is the Standard Deviation data of all the FnO stocks:
Standard Deviation Data of All FnO Stocks
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If you like data driven decision making, then SD analysis can definitely yield a target list of stocks which can offer profitable trading opportunity. Interestingly, this approach also helps you target the stocks which are at their tipping point (high probability of a breakout or break down in a shorter time frame). For example, any stock trading below its -2 SD is statistically eligible for a bounce back towards the mean price. However, the move towards -2 SD price might be due to some fundamentally bad news, in which case the price might break down further - hence the tipping point as large movement is expected in either direction.
Once you have the list of stocks which are at their tipping point, it gets really critical to be correct in your view on the stock (either bullish or bearish) as this will ultimately lead to the strategy you are going to apply.
Here we would suggest that you take help of additional data points like Open Interest Analysis to be doubly sure about your view. Open interest analysis can help you gauge if money is flowing in when stocks are moving up (bullish view) or moving down (bearish view). And once you have data backed view, the chances of failure will diminish further. Having said that, do take care that the FnO contracts of the target stocks or index has enough liquidity.
For the inquisitive mind, here is a nice data backed compilation on How to trade options using Standard Deviation.
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