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Developed by Perry Kaufman and described in his book entitled “New Trading Systems and Methods”, the Efficiency Ratio is a measure of relative market speed to volatility. It is often used as a filter to help avoid “choppy” or flat markets and help identify smoother market trends.
The Efficiency Ratio is calculated by dividing the net change in price movement over n-periods by the sum of all bar-to-bar price changes (taken as absolute values) over those same n-periods.
Interpretation
The smoother the market is trending the greater the Efficiency Ratio. Efficiency Ratio readings around zero indicate a lot of inefficiency and “choppiness” in the market movements.
For example, the Efficiency Ratio will read +100 for an instrument that is up-trending with perfect efficiency and -100 for an instrument that is down-trending with perfect efficiency. Obviously, it is virtually impossible for an instrument to have a perfect efficiency ratio since any adverse movement against the prevailing trend direction during the time period being evaluated would decrease the efficiency ratio.
Efficiency Ratio values above +30 generally indicate a smoother uptrend while values below -30 generally indicate a smoother downtrend. However, it’s important that you experiment with these values to determine the most appropriate levels for the instrument(s) being evaluated and the trading methodology being used.
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