Efficiency Ratio for momentum trading

The Efficiency Ratio (ER) is used in technical analysis to spot periods of strong and weak trends. Low Efficiency Ratio readings are an indication of a weak trend and high Efficiency Ratio readings are a sign of a strong trend

One of the biggest question in technical analysis is how to recognize periods of side-way trending when it is preferable remaining in cash. In most cases, strong trends are short-lived and side-way trends are prolonged in time. We may have 5-day strong trend and then we may run into a month of side-way trending.

The Efficiency Ratio is very simple in use.

Calculation:
ER = Change / Sum of absolute changes

where “Change” is a price change over specified period and “Sum of Changes” sum of absolute price movements within that period

As an example, to calculate 5-day ER you have to calculate 5-day change and then calculate absolute sum of each day movements:

5-day ER = 5-day change / (|day 1 change| + |day 2 change| + |day 3 change| + |day 4 change| + |day 5 change|)

In Kaufman’s book Smarter Trading: Improving Performance in Changing Markets, he notes that the efficiency of a trend is calculated by dividing the net movement over a certain time period (I use 20 trading days), divided by the summation of the absolute value of the day-to-day price changes over the same time period. So if a stock’s trend is at perfect efficiency, as an example it could move up say 20 points over 20 days, and each of those days it moved up by exactly 1 point. This would mean that the ratio of net movement over combined movement was 20/20, or 1.00 (I plot it as +100 for positive efficiency). If the stock downtrends by 20 points with the same perfect efficiency, its maximum downtrend reading would be -100.

Obviously it is virtually impossible for a stock to have a perfect efficiency reading, as any adverse movement against the trend during the time period examined will lower the efficiency reading. What I’ve found from my testing is that Efficiency Ratio readings above +30 are very favorable to define persistent up-trends while readings under -30 often denote steady downtrends.

The Efficiency Ratio is a useful filter in your trading arsenal to screen out many choppy stocks where breakouts may prove to be fake-outs, and allow you to only focus on the best of the best trends. The BigTrends Price Headley method for Efficiency Ratio is not widely available in most trading packages, which makes it even more valuable in my view.