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Standard
Deviation Channel
Description
Standard
Deviation Channels are calculated by plotting two
parallel lines above and below an x-period linear
regression trendline.
The lines are plotted x
standard deviations away from the linear
regression trendline.
For
information on other channel-based line studies,
see Envelopes,
Raff
Regression Channels, Standard
Error Bands, and Standard
Error Channels.
Interpretation
Price
movements are characterized by swings from one
extreme to the other.
Markets reflect the collective mood if its
participants. When
market participants are overly optimistic, prices
are driven up at an unsustainable rate.
Likewise, when market participants are
overly pessimistic, prices are beaten down at an
unsustainable rate.
The keywords here are "extreme"
and "unsustainable."
Even the most raging bull markets or
violent bear markets will either pause for a
breather or reverse temporarily.
Markets
tend to have an equilibrium point (i.e., a point
towards which prices tend to be drawn).
Linear regression analysis is helpful in
determining where this "balancing point"
lies. On
the other hand, standard deviation analysis is
helpful in determining where the
"extremes" lie.
Elementary
statistical analysis states that approximately 67%
of future price movement should be contained
within one standard deviation and approximately
95% within two standard deviations.
However, this assumes random, trendless
data. Since
most markets show overwhelming evidence of
non-random, trending behavior, these 67% and 95%
values are not as accurate.
Standard Deviation channels, however,
incorporate the trend (as measured by the middle
linear regression plot).
Therefore, they provide a trend-biased
assessment of expected price movement.
Standard
Deviation Channels can be used to enhance several
types of technical analysis techniques.
Here are some ideas:
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Validate
candlestick patterns:
Enter long on bullish engulfing lines
only if they form below the bottom channel
line.
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Validate
overbought/oversold signals:
Close long (or enter short) when the
Stochastic falls below 80, volume is above
average, and prices have recently fallen below
the top channel line.
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Validate
support/resistance breakouts:
If prices have broken above a long-term
resistance level, yet volume is suspiciously
light, wait until the prices break above the
upper channel on above average volume.
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