The Efficiency Ratio, developed by Perry Kaufman and introduced in his book “New Trading Systems and Methods,” indicates the relative market speed to volatility. In some circumstances, it is used as a filter to assist traders in avoiding “choppy” markets or trading ranges and identifying smoother patterns. It is calculated by dividing the net change in price movement over n times by the total of all bar-to-bar price changes over the same n periods.
What is the Kaufman Efficiency Ratio Indicator?
The Kaufman Efficiency Ratio indicator for MetaTrader is a technical trading tool that defines the bias of a trend using a concept known as the Kaufman Efficiency ratio. This straightforward indicator also measures an asset’s price extremes. The indicator is intended to assist you in identifying price extremes (overbought/oversold) denoted by the numbers 0 and 1. Level 0 on the indicator represents the oversold zone, while level 1 represents the overbought zone. This indication is also useful for beginning, intermediate, and advanced traders. It can also be utilized for other trading strategies like scalping, day/intraday trading, and swing trading.
Kaufman Efficiency Ratio Strategy
The ER measures the quantity of market noise. The random and irregular price movement that surrounds any underlying market direction is referred to as noise. The ER is determined by dividing the absolute net price change by the absolute sum of the individual price changes across the time. Closing prices are employed. The ER varies between 0 and 1. ERs in trending markets are often closer to one, whereas ERs in unsettled markets are closer to zero. The ER, like other indicators, is displayed as a rolling average.
If you follow a trend, you may want to enter the market when the ER is high. In contrast, mean reversion methods could be implemented when the ER is low. The ER entrance threshold value is very subjective. How high, for example, must the ER value be in order for a trend following entry to be permitted? Regrettably, there is little agreement on what this barrier should be. Before deciding on a value, you might look at the historical ER values in your market to see what is regarded an ‘average’ value. Then, depending on how severe you want your entry filter to be, you could choose a threshold value.
Buy Signal
The following could be your checklist for a buy trade:
- When the asset being traded is in an uptrend.
- When the indicator is pointing upwards from the oversold region.
Once these events occur:
- You could open a buy position after you confirm your entry with bullish candlestick patterns.
- You could set your stop loss just below the nearest swing low.
- You could set your take profit at the nearest resistance zone, or you could exit trade when the indicator enters the overbought region.
- For good risk management, I would only consider trades with a risk to reward ratio of at least 1:2.
Sell Signal
The following could be your checklist for a sell trade:
- When the asset being traded is in a downtrend.
- When the indicator is pointing downwards from the overbought region.
Once these events occur:
- You could open a sell position after you confirm your entry with bearish candlestick patterns.
- You could set your stop loss just above the nearest swing high.
- You could set your take profit at the nearest support zone, or you could exit trade when the indicator enters the oversold region.
- For good risk management, I would only consider trades with a risk to reward ratio of at least 1:2.
Kaufman Efficiency Ratio Pros & Cons
Pros
- The Kaufman Efficiency Ratio Indicator can be used as an entry filter in a trend following approach to screen out impulsive moves that may indicate the start of a long trend.
- This indicator helps traders to identify possible overbought and oversold regions so that they could act accordingly.
Cons
- It is impossible for any instrument to have a perfect Efficiency ratio because any deviation from the major trend throughout the time period under consideration would cause the ratio to fall.
- The ER appears to increase return/max drawdown only when the threshold is between 0.45-0.60. When only a restricted range of parameters is effective, it does not inspire confidence.
Conclusion
The Kaufman Efficiency Ratio indicator for MT4 is a nice trading tool that provides a picture of various market moods. It also aims to spot trending and sideways (ranging) markets. The Kaufman Efficiency Ratio is a straightforward way for quantifying market noise. In other words, it measures how smoothly prices move from one level to the next. It can be used as an entry filter in a trend following approach to screen out impulsive moves that may indicate the start of a long trend. Entries will be permitted only if the ER surpasses a specified threshold. If you want to employ the efficiency ratio in a countertrend strategy, you may want to allow entries when the ER is below a specified level.
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