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.


 

In this swing trading example the Kaufman ER strategy is applied on a daily chart of a French stock, Air France. A buy signal is given when the ER crosses above +0,6. A long position was bought at the market price at the next open. The profit target (green line) was reached two weeks later. By that time the 10-period low stop (red line) was already above the break-even level and it was no longer possible to lose on this position.


 

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.