An oscillator that compares the market speed to volatility in an attempt to identify choppy versus smooth markets.
Overview
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.
Kaufman’s Efficiency Ratio on a 4H gold chart 4/16/2011
Source: VT Trader
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.
