Standard deviation channel is also alternatively referred to as the Linear Regression channel. In the course of this article, we will use both the words as they mean the same. As the name implies, the Standard deviation is a channel with an upper and lower range which are placed ‘x’ standard deviations away. The Standard deviation channel operates on the concept of reversal to the mean or price equilibrium.
When it comes to plotting the standard deviation channel, traders must specify the time frame, or the number of bars for which they want the deviation channel to be plotted. Based on this input, if a trader selects 100 bars, then the standard deviation channel is automatically plotted.
Ideally, the Standard deviation channel is used to find market tops and bottoms for the specified period of time. Traders should note that these tops and bottoms that form within the channel are not the tops and bottoms for the major trend, but only for the past ‘x’ bars. Therefore, a market top which forms for a 100 day standard deviation only implies that a high was made for the past 100 days and does not imply a change of trend.
Why use the Standard Deviation Channel?
The Standard deviation/Linear Regression channel is unique unlike other indicators which are mostly based on price and thus lag. On the contrary, the standard deviation channels simply plot ‘trend lines’ if they can be called that which imply potential market reversal for the period of time being used.
This uniqueness of the channel thus makes it a good indicator to confirm any buy or sell signals. Typically, longs are initiated at the lower channel while short positions are taken at the upper channel. As mentioned earlier in this article, the channel works on the concept of reversion to the mean, which is why shorts are taken on the upper and longs are taken up on the lower channel.
Using the Standard Deviation Channel
Most trading platforms tend to automatically plot these channels based on the number of periods selected. It also means that the linear regression channel works across any time frame. Traders simply have to specify the start and end date and the channel is plotted automatically. Of course, traders could also make use of a manual standard deviation channel tool to plot the channels according to their wishes.
In the chart below, we have plotted a 100 day standard deviation channel for EURUSD. As you can see, the channel articulates price tops and bottoms. The vertical line shows the historical data used to come up with this channel thus all the price candles we see after the vertical line were printed in real time.
Obvious from the above chart, it is quite easy to see how the market bottomed out on the 7/11 before price resumed higher. However in real time it would be difficult to pick out these tops and bottoms. Thus, using an oscillator or a moving average can be beneficial to the trader to help improve the odds of success with the Linear Regression/Standard Deviation Channel.
The standard deviation channel works on the concept of creating two parallel lines above and below a mean set at a specific standard deviation. When price touches one of the either extremes of the channel, it is expected for price to return to its mean. Traders buy and sell accordingly.
How to trade with the Standard Deviation Channel?
While there are a number of ways to use the standard deviation channel, we’ll explore a few quick ones.
One way to trade with the Standard deviation channel is to focus only when price has moved from the extreme (or the median). Thus, when price made a sharp reversal from the bottom, one could infer that price made a higher high. Given that the Std. deviation channel is pointing upwards, it would be wise to only take on long positions.
After making a higher low, we see price gradually pushing higher. A trigger point would be when price closes above the previous high (represented by the orange line). A secondary confirmation also comes from the piercing line candle formation, which is bullish.
Another way to trade this would be to make use of an oscillator which makes it easy to spot divergences and trade in the direction of the slope of the channel. The standard deviation or linear regression channel is very simple to use and provides visual clues to the trader, unlike using other indicators, due to its static/mathematical nature, the standard deviation channel does not lag and provides a fair idea on where price can reverse.