Standard Error Bands – Rules, Settings, Strategy, Returns

As traders, we rely on many different technical tools for analysis to gain meaningful insights into market trends, and one tool that tracks the trend effectively is the Standard Error Bands. What do you know about this indicator?

The Standard Error Bands is a technical indicator that tracks the market trend and volatility using the linear regression line and the standard error of the regression. Similar to Bollinger Bands, Standard Error Bands consist of three lines — the middle line is a smoothed 21-period linear regression curve of the price; the upper band is a smoothed two standard errors added to the regression line; and the lower band is a smoothed two standard errors subtracted from the regression line.

In this post, we will take a look at most of the questions you may have about the standard error bands: what it is, how it works, and how you can improve your trading strategies with it. Read on!

Key takeaways

• Standard Error Bands is a technical indicator used to track market trend and volatility.
• It uses a linear regression line and the standard error of the regression to form bands similar to Bollinger Bands.
• The indicator consists of three lines:
  • Middle line: A 3-period simple moving average (SMA) of a 21-period linear regression curve of the price.
  • Upper band: A 3-period SMA of the regression line plus two standard errors.
  • Lower band: A 3-period SMA of the regression line minus two standard errors.
• While similar to Bollinger Bands, Standard Error Bands provide different information:
  • They indicate both the current trend direction and volatility around it.
  • Bollinger Bands, in contrast, typically reflect volatility around a moving average of the price.
• Interpretation:
• QuantifiedStrategies.com backtests a Standard Error Bands trading strategy.
• More indicators are available if you click here: best technical trading indicators.

What are Standard Error Bands in trading?

In trading, the Standard Error Bands is a technical indicator that tracks the market trend and volatility using the linear regression line and the standard error of the regression. Similar to Bollinger Bands, Standard Error Bands consist of three lines — the middle line is a 3-period simple moving average (SMA) of a 21-period linear regression curve of the price; the upper band is a 3-period SMA of two standard errors added to the regression line; and the lower band is a 3-period SMA of two standard errors subtracted from the regression line.

While the indicator is similar to Bollinger bands, it is interpreted differently. It shows both the direction of the current trend and the volatility around it, whereas Bollinger bands typically show the volatility around the plotted moving average of the price.

For instance, when the Standard Error Bands slope in one direction and are contracting, the market is trending strongly and likely to continue. However, when the bands are expanding, it means that the trend is no longer strong, and you might see the Linear Regression line leveling off or even reversing — indicating a sideways market or a market reversal, as the case may be.

This is what it might look like on a chart:

Standard Error Bands trading strategy – rules, settings, and returns

Let’s backtest a trading strategy that has the following trading rules:

THIS SECTION IS FOR MEMBERS ONLY. _________________ BECOME A MEBER TO GET ACCESS TO TRADING RULES IN ALL ARTICLES CLICK HERE TO SEE ALL 400 ARTICLES WITH BACKTESTS & TRADING RULES

(Please look at the code below if you are unsure of the trading rules.)

The trading rules are simple. We backtest them on all stocks included in the S&P 500 from 1990 until today (no survivorship bias). We backtested only stocks that closed above 10 dollars and had an average volume of at least 5 million shares traded.

This is the equity curve, including 0.03% commissions for each trade (0.06% for a round trip):

We allocated 20% of the equity to each position. Thus, we can hold 5 positions.

Trading performance metrics and statistics from inception until today (including 0.03% commissions per trade):

• Number of trades: 2438
• Average gain per trade: -0.67%
• Annual returns: 9.3%
• Win rate: 64%
• Time spent in the market: 33%
• Risk-adjusted return: 28%
• Max drawdown: 22%

As a starting point, we believe the strategy shows great promise.

This is the code we used for the backtest (Amibroker):

THIS SECTION IS FOR MEMBERS ONLY. _________________ BECOME A MEBER TO GET ACCESS TO TRADING RULES IN ALL ARTICLES CLICK HERE TO SEE ALL 400 ARTICLES WITH BACKTESTS & TRADING RULES

How do Standard Error Bands work in trading strategies?

In trading strategies, Standard Error Bands work both as trend-following and volatility indicators. The slope of the linear regression line (the middle line) shows the direction of the trend, while the narrowing or widening of the upper and lower bands indicates the nature of market volatility.

When the linear regression line is sloping upwards, the trend is to the upside, and when it is sloping downward, the trend is to the downside. The steeper the slope, the stronger the trend. When the Linear Regression line levels off, the market has turned sideways.

On the other hand, when the market is trending and the bands narrow, it shows that the trend is healthy, but when the bands widen, the market has become volatile and could reverse or move sideways.

Why should traders use Standard Error Bands?

Traders use Standard Error Bands because the indicator helps them to identify the direction of the trend, as well as assess its strength and health. They can use the middle line or the linear regression line to spot the trend and the upper and lower bands to gauge the strength and health of the trend.

The indicator may also be used to generate trade signals. First, it can signal a trend setup when the price crosses the indicator and the slope of the middle line follows suit. Interestingly, in such a trade, the upper or lower band — as the case may be — can be used to trail profits and ride the trend to its conclusion.

In situations where the bands form a channel around the price, the upper and lower bands may signal overbought and oversold conditions, and the price crossing beyond them and reversing may set up a mean-reversal trade.

How are Standard Error Bands calculated?

To calculate the Standard Error Bands, these are the steps to follow:

1. Calculate a 21-period Linear Regression Line
2. Calculate the standard error of the linear regression line
3. Calculate a 3-period SMA of the linear regression line to get a smoothed linear regression line, which forms the middle line of the indicator
4. Smoothen the standard error by getting a 3-period SMA of the standard error
5. Plot the upper band by adding two smoothed standard errors to the smoothed linear regression line
6. Plot the lower band by subtracting two smoothed standard errors from the smoothed linear regression line

What is the difference between Standard Error Bands and Bollinger Bands?

The difference between Standard Error Bands and Bollinger Bands is that the latter measures the variance or degree of volatility around the average price using the standard deviation, while the former measures the standard error of the estimate around a 21-period linear regression line.

In Bollinger bands, the middle band is a moving average of the price, but in Standard Error Bands, the middle band is derived from the ending value of a 21-period linear regression line. Also, the upper and lower bands in Bollinger bands are gotten by adding and subtracting, respectively, two standard deviations to the middle line.

In the standard error bands, the upper and lower bands are derived by adding and subtracting, respectively, two smoothed standard errors to the ending value of the regression line.

How do Standard Error Bands help in identifying trends?

Standard Error Bands help in identifying trends through the slope of its middle band. The direction of the slope of the linear regression line shows the direction of the trend.

Thus, when the slope of the linear regression line is pointing upwards, the trend is to the upside, and when it is pointing downward, the trend is to the downside. The steeper the slope, the stronger the trend. When the Linear Regression line levels off, the market has turned sideways.

What is the significance of Standard Error Bands in volatile markets?

The significance of Standard Error Bands in volatile markets depends on whether the market is trending or not. Generally, the expansion and contraction of the upper and lower bands signify the volatility in the markets. In volatile markets, the bands are likely to be expanding.

But if the market is trending and the trend is strong, the bands will likely be contracting until there is a major pullback or sideways market, or reversal where the bands expand again.

How can Standard Error Bands signal potential reversals?

Yes, Standard Error Bands can signal potential reversals if the following conditions are met. First, the price would cross to the other side of the indicator — for example, if the price was above the indicator, crossing below the indicator is the first sign that a potential price reversal may be coming.

The second condition is that the slope of the middle band must turn to the new direction. So, in the case of a downward reversal, the price crossing below the indicator would be followed by the middle band sloping downward.

Do Standard Error Bands work for day trading?

Yes, Standard Error Bands can work for day trading if used on the right timeframe and with a suitable strategy that has an edge in the market. The most common timeframes for day trading are intraday timeframes, such as the hourly, 30-minute, 15-minute, and probably 5-minute timeframes.

When used on any of these timeframes with a strategy that has been proven to be profitable, it can work very well. But the key thing is to create a good strategy for day trading and backtest it on different intraday timeframes to know where it works the best.

How do Standard Error Bands react to price movements?

Standard Error Bands react to price movements in two distinct ways:

1. The slope of the middle band: When the market is trending, the slope of the middle line (the linear regression line) points in the direction of the trend. In an uptrend, the middle band slopes upward, while in a downtrend, it slopes downward. It stays flat in a ranging market.
2. The contraction/expansion of the outer bands: When the market is trending market strongly, the outer bands of the indicator contract, signaling that the trend is healthy and likely to continue. When the market starts pulling back or turning sideways, the outer bands expand.

What role does volatility play in Standard Error Bands?

The role that volatility plays in Standard Error Bands depends on whether the market is trending or not. Generally, the level of volatility in the market determines whether the upper and lower bands of the Standard Error Bands indicator are expanding or contracting.

When there is too much volatility in the market, with price bars spiking up and down, the bands are likely to be expanding. But if the market is trending and the trend is strong, the bands will likely be contracting until there is a major pullback or sideways market, or reversal where the bands expand again.

Can Standard Error Bands help reduce trading risk?

Yes, Standard Error Bands can help reduce trading risk but not directly as it does not determine your position size or initial stop loss. However, if you are using a trend-following strategy, which is what the indicator is mostly good for, you can use the relevant outer band to guide your trailing stop.

For a long trade in an uptrend, you can trail your profit by keeping your trailing stop at a certain distance below the lower band. Likewise, if you’re short in a downtrend, you can trail your profit by keeping your trailing stop at a certain distance above the upper band.

How do you set up Standard Error Bands in trading software?

To set up Standard Error Bands in trading software, go to the indicator section of your trading software to see if it has a built-in standard error bands indicator. If it does, double-click on it to attach it to your chart.

If the software does not have the indicator pre-installed, you can get a custom indicator and install it first before you can set it up on the chart. You can pay a programmer to create the indicator for your trading software.

What are the best timeframes for using Standard Error Bands?

The best timeframes for using Standard Error Bands will depend on the trader’s style of trading. If the trader is a day trader, they may want to use any of the intraday time frames, such as the hourly, 30-minute, or 15-minute time frame.

A swing trader may use the 4-hourly or daily time frame. To know the best time frame, the trader will have to backtest their strategy to know where it works best.

How do Standard Error Bands differ from moving averages?

Standard Error Bands differ from moving averages in that the former uses a linear regression line to estimate the moving mean of the price series, while the latter calculates the average price.

Also, the standard error bands indicator has an upper and a lower band that are derived from the standard error of the regression line, while moving averages only consist of their moving average lines without outer bands. However, an SMA smoothening is often applied to the standard error bands to smoothen the data.

Are Standard Error Bands suitable for all asset types?

Yes, Standard Error Bands may be suitable for all asset types because it is calculated from the price data only, which are usually available for all asset types. This is unlike volume-based indicators that cannot be applied to asset types, such as spot currencies, where the total trading volume is not available.

However, whatever the asset type you want to analyze with the standard error bands, be sure the market is trending, as the indicator is more suitable for trending markets.

What are the pros and cons of Standard Error Bands?

The pros and cons of Standard Error Bands are many. Here are some of the pros:

• Traders can use it to identify trends more effectively than most moving average-based indicators.
• It can be used to confirm the strength and health of an existing trend.
• The width of the outer bands can provide valuable insights into market volatility.
• The indicator may be used to create entry and exit signals.

These are some of the cons:

• It may not be suitable to use the indicator alone.
• It can give many false signals.
• It is not suitable for range-bound markets

Can Standard Error Bands be used for automated trading systems?

Yes, Standard Error Bands can be used for automated trading systems if a reliable strategy that can be converted to a trading algorithm is created with the indicator.

The most important thing is that the strategy is simple enough to be automated and reliable enough to have an edge in the market. You can confirm the edge via backtesting and forward-testing.

What settings should you use for Standard Error Bands?

The settings should you use for Standard Error Bands will depend on your trading strategy, the market you’re trading, and the findings from your backtesting. The default settings are usually 21 periods for the linear regression line and 3 periods for SMA smoothening.

However, you have to use the settings that suit your strategy and the market you’re trading. The best way to know the settings to use is by backtesting your strategy with different settings to find the one that works best.

How do you interpret Standard Error Band signals in a trading strategy?

How you interpret Standard Error Band signals in a trading strategy will depend on the strategy and what you’re using the indicator to do. If you are using the indicator solely to identify the direction of the trend while you use other tools for entry and exit, you can simply check the slope of the middle band — up-sloping means an uptrend, downward-sloping means a downtrend, and flat means a ranging market.

However, if you want to use it for entry and exit strategies, you will also need to check the position of the price action relative to the indicator bands.

Can Standard Error Bands predict market tops and bottoms?

No, the Standard Error Bands cannot predict market tops and bottoms, but the indicator can show when a trend has reversed. The slope of the middle band shows the direction of the.

When the trend reverses, not only does the price cross to the other side of the indicator, but also, the slope of the middle band turns to the new direction. However, this often lags the price action by some reasonable number of price bars.

What is the best way to optimize Standard Error Bands in trading?

The best way to optimize Standard Error Bands in trading is to regularly evaluate the performance of the indicator while forward-testing it in a real-time market. This way, you reduce the chances of curve fitting the settings with already known market data.

However, if you have good out-of-sample historical data following your backtesting, you can still optimize the indicator from historical price data.

How can Standard Error Bands improve entry and exit points in trades?

Standard Error Bands can improve entry and exit points in trades in different ways. Firstly, it can be used to identify the direction of the trend and also confirm the validity of the trend so you look for entry points only in the trend direction.

Secondly, it can also be used as entry and exit points for a trend-following strategy. And lastly, it can be used to trail a trend-following trade so you ride the trend to its conclusion before exiting.

What are common mistakes when using Standard Error Bands?

Some of the common mistakes when using Standard Error Bands include:

• Getting into the market without a trading strategy with clear entry and exit criteria
• using the indicator as a standalone strategy to trade mean reversion, which is prone to many false signals
• not having a risk management plan.

How can beginners start using Standard Error Bands effectively?

For beginners to start using Standard Error Bands effectively, they have to learn how the indicator works and understand the kind of market conditions that suit it.

Next, they should create trading strategies with the indicator and open a demo account to practice their strategies in a risk-free environment.