In Kaufman's book Smarter Trading (click here for a summary I created on this book's key points), 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 uptrends while readings under -30 often denote steady downtrends.
For example, one of my best-trending winners in the past month occurred when I bought May 25 calls on Phillips-Van Heusen (PVH) when the stock came back to retest its +30 key level on the Efficiency Ratio on April 15 at the key low of 24.11. If the stock closed under that level, I would have to exit the bullish trade. The stock quickly rallied up to 30.50 over the next 6 trading days, allowing me to execute the "free trade" rule of selling half of my position at a +100% gain in my Options Shark recommendation service. Once the next test of the Efficiency Ratio failed in early May, I exited the rest for a still healthy gain over +50% and managed to avoid the noise and drawdown that ensued back down to the 25 area.
Phillips-Van Heusen (PVH) Daily Chart with 20-Day Efficiency Ratio
The Efficiency Ratio is a useful filter to screen out many choppy stocks where breakouts may prove to be fakeouts, and allow you to only focus on the best of the best trends. One of the few places you can find it is right here in our Tools & Resources section - drop us a comment to let us know how you like the new charting tools!
