Using Efficiency Ratio in your Technical Analysis

Posted by Price Headley on March 9, 2012 10:20 AM

I am always studying my trades to learn what separates my best trades from the rest of the pack.  In addition to techniques like Acceleration Bands, CCI, Percent R and Momentum Divergence, I have noticed that many of the biggest trends I rode were also confirmed by an indicator called the Efficiency Ratio.  I refined the Efficiency Ratio as an actionable technical indicator based on the work of Perry Kaufman, a highly-respected systems developer. 

In Kaufman's book Smarter Trading . 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. 

Here'san example from the past, where we bought PVH calls when the stock came back to retest its +30 key level on the Efficiency Ratio at the key low of 24.11 -- see the chart below.  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.  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 in your trading arsenal 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.  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.  For information on our Trading Education products that include Efficiency Ratio, please call 1-800-244-8736.

Trade Well,

Price Headley