- First, there is an assumption that the distribution starting from the cone's origin, based on the number of historical bars sampled, is likely to represent the distribution of future price.
- Price typically hangs around the mean.
- When price is between the first and second deviation cones, there is a higher probability for a reversal.
- However, strong momentum while above or below the first deviation can indicate a trend where price maintains itself past the first deviation. For this reason it's recommended to use a momentum indicator alongside the cones.
- There is no mean reversion assumption when price deviates. Price can continue to stay deviated.
- It's recommended that the cones are placed at the beginning of calendar periods. Like the month, week, or day.
- Be mindful when using the cones on various timeframes. As the lookback setting, which selects the number of bars back to load from the cone's origin, will load the number of bars back based on the current timeframe.
Second Deviation Strategy
How to react when price goes beyond the second deviation is contingent on your trading position.
- If you are holding a losing trade and price has moved past the second deviation, it could be time to stop trading and exit.
- If you are holding a winning trade and price has moved past the second deviation, it would be best to look at exit strategies to capitalize on the outperformance.
- If price has moved beyond the second deviation and you hold no position, then do not open any new trades.