Trading Systems and Methods, 6th Edition

CHAPTER 18Price Distribution Systems

Price movement is usually seen as a chart in which each new interval is a new bar or point recorded to the right of the previous prices – the traditional time series. There are many applications that need to look at prices differently. Point-and-figure charting only moves to the right when a reversal occurs. A standard deviation looks at the way price changes are spread out. Market Profile, discussed later, studies the clustering of prices.

In pricing options, the implied volatility is used to decide the chances of prices remaining in a specific range for a specific amount of time. When a risk manager evaluates the volatility of returns, the same annualized standard deviation calculation is used. The standard deviation gives the most basic and accepted measure of price distribution. For our applications, we will favor historic volatility, which is easy to calculate and works well.

Because the standard deviation is the most commonly used measurement of price distribution, it is important to remember that a band formed by the average of the data standard deviation contains 68% of the data (both up and down if price changes), standard deviations contain 95%, and standard deviations contain 99.7% of all data. Theoretically, all data should be ...