# The Kaufman Efficiency Ratio and Balanced Momentum In this post we’re discussing the Kaufman Efficiency Ratio, aka Fractal Efficiency, and how it relates to determining market momentum. If you rely on any type of momentum indicator for identifying trading setups, you’ll want to avoid being fooled by the so called dropout effect. The balanced momentum calculation addresses this issue and to learn more on how to avoid it, check out this video, or continue reading below:

## Eliminating the Dropout Effect:

The dropout effect refers to a misleading momentum output, caused by eliminating the last bar in the lookback period. The standard momentum calculation tracks the difference between the close of the last bar and the close n bars ago. Therefore, a bar n periods ago with a close sufficiently removed from the last bar, will create a distortion in the momentum output. Even if there was no or little price change for the last bar, the fact that the bar n periods ago has dropped out of the calculation, will show a change in momentum.

In other words, the indicator will show a momentum change, although price action clearly tells a different story!

To eliminate this problem, one should apply a Balanced Momentum calculation instead. It replaces the input value for the n bars ago, with a triangular moving average:

SMA(SMA(Input, n+1), n+1)

This modification does not change the usability of the momentum indicator, other than eliminating the distortion.

## Efficiency Ratio using Standard vs. Balanced Momentum

The Kaufman Efficiency Ratio, a.k.a. Fractal Efficiency, was developed by Perry Kaufman and determines whether a market is trending or range bound. The Efficiency Ratio is an alternative to the Directional Movement and the ADX indicators and is calculated by dividing the absolute price difference between the current close and the close n bars ago by the sum of the absolute price movements over the N-bar lookback period:

ER = 100 * Math.Abs(Close – Close[N]) / SUM (Math.Abs(Close[i] – Close[i-1])

In a perfect trend, where all bars close in the same direction and do not overlap, the Efficiency Ratio will show a value of 100. A perfect sideways market without momentum in either direction, will show a value of 0.

Specifically, the Efficiency Ratio compares momentum with volatility and as shown below, it can make a significant difference whether the standard or the balanced momentum calculation is applied: