Among all the most useful and a little tough to explain the concept of all is Standard Deviation. In simple words, the standard deviation is “Mean of Mean”. The word Standard Deviation is usually used with a very professional audience. But our efforts are to bring this complicated concept to you as easy as possible for you to understand it and how to use it. Our focus here is more on how to use the concept than calculating it.
Standard Deviation is calculated by a simple formula that is the Square root of Variance.
And Variance is calculated by taking the difference from the mean, square it, and then average the result.
Let us look at the Simple Normal Distribution Chart of Standard Deviation chart. For the stock market, We would require only Normal Distribution.
σ is the symbol of standard deviation. Each band represents one standard deviation. Since it measures the confidence in statistical conclusions. From the below explanation one can understand how each SD signifies different outcomes.
The measurement of confidence level can be better understood when the below-mentioned values are seen on the above chart.
- – 1 Standard Deviation 68.27 % of the data falls into 1 Standard Deviation
- – 2 Standard Deviation 95.45% of the data falls into 2 Standard Deviation
- – 3 Standard Deviation 99.70% of the data falls into 3 Standard Deviation
Range for a specific stock can be calculated based on their Implied Volatility. For example a stock with Current Market Price of Rs. 1000 and with Implied Volatility of 25%.
- – 1 Standard Deviation Rs. 750 to Rs. 1250
- – 2 Standard Deviation Rs. 500 to Rs. 1500
- – 3 Standard Deviation Rs. 250 to Rs. 1750
From the above, we can understand that there is 68% probability that the price of the stock will move in the range from Rs. 750 to Rs. 1250
68% probability that the price of the stock will move in the range from Rs. 750 to Rs. 1250
95% probability that the price of the stock will move in the range from Rs. 500 to Rs. 1500
99% probability that the price of the stock will move in the range from Rs. 250 to Rs. 1750
Now from the above one simple understanding, we can get is that the price movement range will be low for stocks with low implied volatility and for the stock with high implied volatility the stock price range would be very high.
If you are struggling to make a profit in the trade or the profit you are making are taken away by the market then understanding standard deviation could be useful.
If the situation keeps repeating without any real income generation, sooner or later you will find out you’ve wasted your time, energy and money.
If that is the case now is the right time to make necessary adjustments and save from making losses.
Nevertheless, the impact of implementing these corrections the time and other resources you spend in making these adjustments. You might not see more profit with these corrections but definitely, your capital is not going to erode.
Have you experienced this earlier? With this fundamental change have you corrected your strategy? Would you recommend this to a newbie Option Trader? Let’s hear your thoughts in the comments below!
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