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 to identify setups, you’ll want to avoid the so called dropout effect. One may address the issue by using a balanced momentum calculation. To learn more on how to avoid thedropout effect, 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)[0]
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. You may consider the indicator as an alternative to the Directional Movement and the ADX indicators.The Kaufman Efficiency Ratio 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[0] – 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. As can be seen below, it can make a significant difference whether a standard or balanced momentum calculation is applied:
Therefore, if you rely on any other type of momentum indicator for your trading, for example the Rate of Change, you’ll want to know whether it applies a standard or balanced momentum calculation.
Other than allowing traders to choose between a standard and balanced momentum calculation, the Efficiency Ratio indicator displays with paint bars. Bars above the chop line plot in green or red, whereas bars that plot below are yellow.
Adjusting the Chop Threshold
Finally, the threshold value distinguishing between trend and chop adjusts automatically. For example, when using a lookback period of 10 bars, the Efficiency Ratio may show a value of 100 if they all had consecutive up or down closes. However, when using a lookback period of 100, we may never see a perfect Efficiency Ratio of 100. Accordingly, one should set the chop line threshold lower for longer lookback periods. Our KaufmanEfficiency Ratio indicator does so automatically, eliminating manual adjustment.
Using the Kaufman Efficiency Ratio:
This indicator located in the Trend Analysis category of the LizardIndicators Library. You may consider combining alining its trend bias with the Squeeze indicator, available via oscillator values or channel lines. Furthermore, you may use the Better Volume indicator to confirm these setups. You may review the Kaufman Efficiency Ratio indicator via the below NinjaTrader Indicators Library link:
The indicator is available for NinjaTrader 8.
