Efficiency Ratio Strategy – Video, Performance And Rules
In trading, it is often said that the trend is your friend, but to follow the trend, you need to have a tool to separate the trend from market noise — this is where the Efficiency Ratio comes in. What do you know about this indicator?
Different from the efficiency ratios of corporations, the Efficiency Ratio in trading is a technical indicator that estimates the presence and relative strength of a trend based on the ratio of the price direction to the price volatility. Specifically, it is the ratio of the change in closing price over a given period to the sum of the price movements that occurred to achieve that change.
In this post, we will take a look at most of the questions you may have about the Efficiency Ratio indicator: what it is, how it works, and how you can improve your trading strategies with it. Let’s dive in!
Efficiency Ratio – video
Key takeaways
- The Efficiency Ratio (ER) in trading is a technical indicator to estimate trend strength based on price direction relative to price volatility.
- It’s calculated as the ratio of the closing price change over a period to the sum of all bar-to-bar price movements within that period.
- Created by Perry Kaufman, it is also known as the Kaufman Efficiency Ratio (KER). ER values range from 0.0 to 1.0:
- Values near 1.0 indicate a strong trend with minimal noise.
- Values near 0.0 suggest high volatility with no clear trend.
- ER helps traders filter out market noise, focusing on identifiable trends rather than random price fluctuations.
- A perfect efficiency ratio of 1.0 would imply a flawless trend, though it’s rare for markets to achieve this consistently over time.
- More indicators are available if you click here: best trading indicators.
What is the Efficiency Ratio in trading?
Different from the efficiency ratios of corporations, the Efficiency Ratio in trading is a technical indicator that estimates the presence and relative strength of a trend based on the ratio of the price direction to the price volatility. Specifically, it is the ratio of the change in closing price over a given period to the sum of the price movements that occurred to achieve that change — i.e., the sum of the bar-to-bar changes in close price over the same period.
Created by Perry Kaufman, the indicator is also known as Kaufman Efficiency Ratio (KER). It offers an interesting way to identify and measure the trend in any financial market. It helps to assess trend efficiency by gauging the speed of price movements relative to market volatility. Traders use it to filter out erratic market noise so they can focus on clear trends.
The indicator’s values range from 0.0 to 1.0. The closer the value is to 1, the more likely there is a trend, and the higher the value, the stronger the trend. Values closer to 0.0 suggest a noisy market without a clear trend. A value of 1 indicates a perfectly efficient trend without noise, but it is nearly impossible for a market to have a perfect efficiency ratio, especially over a long period.
Generally, the indicator comes with a value range of 0.0 to 1.0, which can only show the presence of a trend and its strength but cannot show the direction of the trend. See the chart above. However, on some trading platforms, you have a setting option that enables it to show direction, in which case, the indicator’s values range from -1 to +1, with values above 0.0 (positive) indicating an uptrend and values below 0.0 (negative values) indicating a downtrend. Values around 0.0, as usual, indicate a noisy, trendless market.
Efficiency Ratio trading strategy – rules, settings, and returns
Let’s backtest a trading strategy that has the following trading rules:
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(Please look at the code below if you are unsure of the trading rules.)
The trading rules are simple, producing the best results for assets that tend to trend. This is the equity curve for S&P 500 (SPY) from its inception until today including 0.03% commissions for each trade (0.06% for a round trip):
Trading performance metrics and statistics from inception until today (including 0.03% commissions per trade):
- Number of trades: 324
- Average gain per trade: 0.75%
- Annual returns: 7.3%
- Win rate: 60%
- Time spent in the market: 64%
- Risk-adjusted return: 11.4%
- Max drawdown: 25%
This is the code we used for the backtest (Amibroker):
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CLICK HERE TO SEE ALL 400 ARTICLES WITH BACKTESTS & TRADING RULES
How does the Efficiency Ratio measure market trends?
The Efficiency Ratio measures market trends by estimating the ratio of the price direction to the price volatility. In other words, it calculates the ratio of the change in closing price over a given period to the sum of the bar-to-bar changes in close price over the same period.
The resulting values range from 0.0 to 1.0, or from -1.0 to +1.0 if the directionality function is applied. When the value is significantly greater than zero, it means there is likely a trend in the market — the closer to 1, the stronger and more efficient the trend. A ratio of 1 indicates a perfectly efficient trend without noise, but it is nearly impossible for a market to have a perfect efficiency ratio except the period is very short and the price bars just moved in one direction all through.
If the price bars spike up and down during the given period, the sum of the bar-to-bar price changes (the denominator) becomes very large compared to the numerator, so the ratio approaches zero. Thus, the closer the value is to zero, the choppier or noisier the market is. When it has a value of 0.0, it means the prices are unchanged over the given period.
In situations where the indicator has a directionality function, positive values suggest an uptrend, and the higher the value, the stronger the uptrend. Negative values indicate a down-trending market, and the closer the value is to -1.0, the more efficient and stronger the downtrend.
Who developed the Efficiency Ratio indicator?
Perry J. Kaufman developed the Efficiency Ratio indicator and introduced it to the trading community in 1995. He presented it as a part of his market efficiency model, which he explained in his book titled, “Smarter Trading: Improving Performance in Changing Markets”.
Kaufman is an active stock and derivatives trader who has been speaking, writing, and teaching trading systems and methods via various media platforms. Wikipedia described him as follows:
“An American systematic trader, rocket scientist, index developer, and quantitative financial theorist. He is considered a leading expert in the development of fully algorithmic trading programs.”
What is the formula for the Efficiency Ratio?
The formula for the Efficiency Ratio is as follows:
Efficiency Ratio = (Price change over N periods) / (Sum of the absolute price changes over N periods)
Where:
- Price change over N periods = Current Closing Price — Closing Price N-period ago.
- Sum of the absolute price changes over N periods = the sum of the bar-to-bar price changes within the N periods.
Thus, the Efficiency Ratio formula can also be written as:
Efficiency Ratio = [Current Closing Price — Closing Price N-period ago] / [Sum of the bar-to-bar price changes over N periods]
How is the Efficiency Ratio calculated in trading?
In trading, the Efficiency Ratio is calculated as follows:
- Record the current closing price.
- Find the closing price N period ago.
- Calculate the price directional movement by the result of step 2 from step 1.
- Find the absolute bar-to-bar price changes over the N periods by subtracting each closing price from that of the next bar up until the current bar, starting from the bar N-period ago.
- Calculate the volatility over the N periods by summing the absolute bar-to-bar price changes over the N periods.
- Divide step 3 by step 5 to get the Efficiency Ratio.
Why is the Efficiency Ratio useful for traders?
The Efficiency Ratio is useful for traders because it offers an interesting way to identify and measure the trend in any financial market. It helps to assess trend efficiency by gauging the speed of price movements relative to market volatility. Traders use it to filter out erratic market noise so they can focus on clear trends.
When the value is well above 0.0, it tells traders that the market is trending, and the higher the value, the stronger the trend. When the value is very close to 0.0, it suggests a noisy market without a clear trend.
How does the Efficiency Ratio compare to other trend indicators?
Compared to other indicators, such as moving average and momentum oscillators, which try to show the direction or momentum of a trend respectively, the efficiency ratio determines if there is a trend and gauges the strength of the trend.
While moving averages measure the average price over a given time, the efficiency ratio measures the ratio of directional price movement to the market volatility over a given period. The latter provides an interesting way to filter market noise and identify the trend.
What are the typical values of the Efficiency Ratio?
The typical values of the Efficiency Ratio range from 0.0 to 1.0, with values close to 0.0 indicating a noisy market and values close to 1.0 indicating a trending market. The closer the value is to 0.0, the choppier the market, and the closer to 1.0, the stronger the trend.
This value range does not typically indicate the direction of the trend. However, on some trading platforms, there can be a setting option to show direction. In this case, the indicator’s values range from -1 to +1, with values above 0.0 (positive) indicating an uptrend and values below 0.0 (negative values) indicating a downtrend. Values around 0.0, as usual, indicate a noisy, trendless market.
What does a high Efficiency Ratio indicate in the market?
In the market, a high Efficiency Ratio indicates that there is likely a trend. A high efficiency ratio is a value greater than 0.5 — the higher the value (the closer to 1.0 it is), the more efficient and stronger the trend.
A value of 1 indicates a perfectly efficient trend without noise, but it is nearly impossible for a market to have a perfect efficiency ratio unless the period is very short and the price bars just move in one direction all through.
What does a low Efficiency Ratio suggest about price movement?
What a low Efficiency Ratio suggests about price movement is that there is a lot of market noise. A low efficiency ratio occurs when the price bars spike up and down during the given period, such that the sum of the bar-to-bar price changes (the denominator) becomes very large compared to the numerator, making the ratio approach the zero value.
The closer the value is to zero, the choppier or noisier the market is — or a tightly consolidating market. A value of 0.0 means the prices are unchanged over the given period.
How can the Efficiency Ratio help identify market noise?
The Efficiency Ratio helps identify market noise by displaying values that are close to 0.0. When the indicator’s readings are around 0.0, it means that the volatility measure (the sum of the bar-to-bar price changes), which is the denominator in the formula is very large compared to the directional price change (the numerator).
This happens when the price is spiking up and down with no clear direction, which is termed as market noise.
When should traders use the Efficiency Ratio?
Traders should use the Efficiency Ratio when they want to know if there is a trend in the market and how strong/efficient the trend is. While they can use it to know whether the market is trending or not, the indicator typically does not show the direction of the trend unless the directional function is included.
So, they may have to analyze the price chart or other indicators to identify the direction of the trend.
What is the best time frame to apply the Efficiency Ratio?
The best time frame to apply the Efficiency Ratio will depend on your trading style, strategy, and backtesting result. If you’re a day trader, you may want to use an intraday time frame, such as the hourly 30-minute, or 15-minute time frame, whereas a swing trader would be concerned with higher timeframes like the 4-hourly and daily timeframes.
But ultimately, it is by backtesting your strategy on different timeframes that you will find out the best timeframe to trade with the indicator.
Can the Efficiency Ratio predict reversals in trends?
No, the Efficiency Ratio does not predict reversals in trends, but it can show when a new trend emerges again. The typical efficiency ratio does not even show the direction of the trend. However, if it is set up with the directionality function, the indicator can show the direction of the trend — rising values above zero indicate an uptrend, while falling values below zero indicate a downtrend.
Values close to zero indicate a directionless noisy market.
How does the Efficiency Ratio work with moving averages?
The Efficiency Ratio can work with moving averages to identify both the presence and strength of a trend and the direction of the trend. Since the typical efficiency ratio does not show the direction of the trend, it makes sense to combine it with moving averages which can show the trend direction.
Apart from the trend direction, moving averages can serve as dynamic support and resistance levels where traders can look for trade setups in the direction of the trend following a pullback.
Is the Efficiency Ratio suitable for day trading?
Yes, the Efficiency Ratio can be suitable for day trading if used on the right intraday timeframe with a good day trading strategy. Intraday timeframes for day trading are usually the hourly, 30-minute, and 15-minute timeframes.
If you have a good strategy and your backtesting results show that it has a positive expectancy when applied on any of the intraday timeframes, then, the indicator can be suitable for day trading.
Can the Efficiency Ratio be combined with other indicators?
Yes, the Efficiency Ratio can be combined with other indicators to get the best out of your trading. In fact, the indicator may need to be combined with other indicators or price action analysis to have a robust strategy because it mostly shows whether the market is trending or noisy, and not trading setups.
It can be combined with moving averages, momentum oscillators, and volume indicators, depending on the trading strategy.
What are the limitations of the Efficiency Ratio?
The limitations of the Efficiency Ratio include the following:
- The indicator mainly shows whether the market is trending or noisy and does not tell you when to buy and when to sell, so it is not very useful as an entry and exit signal
- The indicator is quite sensitive to price changes, especially if the lockback period is short, and this can lead to many false signals during periods of high market volatility.
- It typically does not show the direction of the trend unless the function is set up in the trading platform.
How does market volatility affect the Efficiency Ratio?
Market volatility affects the Efficiency Ratio significantly because it features directly in the calculation of the indicator — it is the denominator. When market volatility is high, the indicator’s readings approach zero. This means that there is a lot of market noise and therefore, not tradable.
On the other hand, when market volatility is low, the denominator won’t be too large, so the indicator value will approach 1.0.
What role does price direction play in the Efficiency Ratio?
The role price direction plays in the Efficiency Ratio is that of the numerator. The directional price change becomes high when the current close is around the high/low of the price range over the specified period.
When the size of the numerator is close to that of the denominator, the value of the indicator approaches 1.0, which signifies an efficient and strong trend.
Can the Efficiency Ratio improve trading strategy performance?
Yes, the Efficiency Ratio can improve trading strategy performance by showing when there is a strong trend to implement the trading strategy and when the market is noisy and directionless so the trader would stay on the sidelines.
However, how well the indicator captures market noise will depend on the lookback period. If the period is short, the indicator might signal a trend when the market is still noisy, thereby giving false signals.
How do you interpret Efficiency Ratio signals?
To interpret Efficiency Ratio signals, you check where the indicator reading is relative to the 0.0 and 1.0 marks. When the indicator is closer to the 1.0 mark, there is a trend in the market. The closer to 1.0, the stronger and more efficient the trend.
On the other hand, when the indicator is closer to the 0.0 mark, the market is choppy — the closer to zero, the choppier.
What are common mistakes when using the Efficiency Ratio?
The common mistakes when using the Efficiency Ratio include:
- trading without an adequate risk management plan
- using the indicator for entry and exit setups
- not combining it with other indicators or price action analysis
- not having a robust trading strategy with clear entry and exit rules
- trading without confirming through backtesting that your strategy has an edge in the market you’re trading
How can beginners start using the Efficiency Ratio?
To start using the Efficiency Ratio, beginners need to first learn how it works so they can create reasonable trading strategies with it. Once they are able to do that, they should open a demo account and practice until they get used to trading with the indicator.
Then, they can formulate and backtest multiple strategies with the indicator to find one with a tradable edge in the market.
Why should traders monitor the Efficiency Ratio regularly?
Traders should monitor the Efficiency Ratio regularly to know when the market is trending or not. In the market, the trend is a friend, especially for traders who use trend-following strategies.
So, it makes sense for traders to regularly monitor a tool that shows the market is trending, and when it is noisy so they can trade during the former and stay on the sidelines during the latter.