Trading strategy: Kaufman Efficiency Ratio
Description
The Kaufman Efficiency Ratio trading strategy is based on Perry Kaufman’s market efficiency model as described in his book "Smarter Trading: Improving Performance in Changing Markets" (ISBN 0-07-034002-1). It is an interesting way to identify and measure the trend of a financial instrument. "The trend is your friend" is a classic trader saying. It implies that trading in the direction of the trend is a safe, conservative approach. However, to follow the trend it is necessary to separate the trend from the random noise of the market - i.e. the random movements of the market at any given time. Kaufman, using his ER, shows if a market is trending or not.
Suitable for | : Market indices (FTSE, DAX, AEX …) : Stocks |
Instruments | : Futures, CFD, stocks |
Trading type | : Day trading and Swing trading |
Trading tempo | : 1-3 signals per day |
Using NanoTrader Full | : Manual or semi-automated |
The strategy in detail
The Kaufman Efficiency Ratio is a ratio of the price direction to the price volatility. The result is a number, which oscillates between +1 and -1. The center point is 0. +1 indicates a financial instrument with a perfectly efficient upward trend. -1 indicates a financial instrument with a perfectly efficient downward trend. It is virtually impossible for an instrument to have a perfect efficiency ratio (+1 or -1). The more efficient the ratio, the clearer the trend.
Values around 0 indicate a lot
of random movement i.e. the absence of a trend. The Kaufman ER
strategy can be used in a 15-minute time frame or higher for
day trading. Lower time frames are not recommended by Kaufman.
The strategy can also be used on a 1-day time frame for swing
trading purposes.
When to open a position?
A buy signal is generated after
the indicator crosses above +0,6. A long position is bought at
the market price. A short sell signal is generated after the
indicator crosses below -0,6. A short sell position is sold at
the market price. Note: as usual users can change the values
of these parameters in the Designer dialog window of the
NanoTrader Full platform:
This example shows a buy signal when the Kaufman ER crosses above the +0,6 level (green zone).
This interpretation scheme uses two parameters, "Threshold Up" and "Threshold Down" that are defined by the indicators using this scheme. As usual in the platform 0 is most bearish (will result in a short signal) and 100 most bullish (will result in a long signal). Hence 50 is neutral (nothing will happen).
By default the Two Zones setup uses the classic "overbought" and "oversold" scenario in order to generate signals. A short sell signal is generated when an indicator leaves the upper zone. A buy signal is generated when an indicator leaves the lower zone. This is the standard interpretation for all "Two Zones" indicators.
The Kaufman Efficiency Ratio indicator, however, follows a different reasoning. A buy signal is generated when the indicator enters the upper zone. A short sell signal is generated when the indicator enters the lower zone. Hence the parameters in the Two Zones interpretation have simply been changed to: 1. "Entering Upper Zone" (100), 3: "Leaving Upper Zone" (50), 5: "Entering Lower Zone" (0) and 7: "Leaving Lower Zone" (50).
The above clearly illustrates once again the enormous flexibility offered by NanoTrader Full. Strategies can be designed without programming.
In order to generate buy and sell signals the indicator uses one of the many basic interpretations schemes of the NanoTrader Full platform called "Two Zones".
This example shows a buy signal after the Kaufman ER crosses above the +0,6 level. Initially the stop (red line) is at the 10-period low. When time elapses the stop follows the 10-period low, resulting in a trailing effect. The position is closed with a profit when the profit target (green line) is hit.
This example shows a buy signal after the Kaufman ER crosses above the +0,6 level. Initially the stop (red line) is at the 10-period low. When time elapses the stop follows the 10-period low, resulting in a trailing effect. The position is closed with a profit when the profit target (green line) is hit.
Conclusion
The Kaufman Efficiency Ratio
strategy tries to identify as strong a trend as possible.
Positions are taken in the direction of the trend. By doing
this Kaufman follows the age old trader saying "the trend is
your friend". It is an interesting, simple-to-understand
strategy which can be used both for day trading and swing
trading. Traders do well to take a look at this strategy as
the trend is a key parameter in trading.
Practical implementation
In NanoTrader Full follow these steps:
- Choose the instrument you wish to trade.
- Open a chart with the template study "WHS Kaufman ER".
- Semi-automated trading? Simply activate the TradeGuard+AutoOrder or the AutoOrder function.