Kaufman’s Market Efficiency Model

Trend Following Methods Applied

The trend following model by Kaufman says that trading by the direction of the trend is a conservative approach to the markets. Kaufman’s Market Efficient Model states that longer trends are the most reliable but they respond rather slowly to changing market conditions. The main argument of the Market Efficiency Model is that an adaptive method must be applied to the markets for proper trend following. Therefore you need a method that speeds up the market entry. The method will not result into a trading signal if the markets are moving sideways.

The method uses an adaptive moving average to calculate the efficiency ratio indicator used to get the desired entry signals. A measure of a trends strength can be useful as some strategies work best on a trending market and some in a range bound market.

Formula for the Efficiency Ratio Indicator :

• ER = Direction / Volatility
• Direction = ABS (Close – Close[n])
• Volatility = n ∑ (ABS(Close – Close[1]))  – the volatility is the sum of the absolute value of the last ten price changes (Close – Prior Close)
• n = The efficiency ratio period. – we used n=10 for our backtests

The Market Efficiency Model combines noise (volatility) and the speed of the price movement. Essentially it divides the net price movement between two time periods by the sum of the individual price movement. This gives us a ratio for the speed of the movement compared to the volatility of the market. Kaufman’s original model uses 10 days but the number can be adjusted according to the market you want to trade. The ratio can be used as a filter that can be mapped onto a range of different time frames to further improve the entry signals.

For testing purposes we look at the Sugar 11 futures market.

Testing parameters :  

• Bar Period=Daily, Profit taking= $900, Stop Loss=$600,
• n=10,
• Short if efficiency ratio is greater than 0.80,
• Long if efficiency ratio is below -0.80.

Results:

In statistical terms, the Efficiency Ratio tells us the fractal efficiency of price changes. ER fluctuates between 1 and 0. For n=10 the efficiency ratio indicator would be 1 if prices moved up 10 consecutive periods or down 10 consecutive periods.

After testing the entry signals for the different ratios we performed another test changing the n periods trying to increase the number of trades and making the results statistically more reliable. Testing parameters same as above except that the n periods for our long/short entry signals are tested for n=0-15. Number of tests: 30,976.

Results:

Optimized parameters: Profit Taking= $1000, Stop Loss= $700, Long Entry n=11, Short Entry n=6

Conclusion: The n = efficiency ratio period is greater in a uptrending market than it is for a downtrending market thus telling us that a bearish market is moving faster. In other words when entering a long position in a bearish market your stop-loss will be reached sooner than in an uptrending market. It also means when entering a short position in a downtrending market you will be able to reach your profit target at a faster pace. We performed these tests on several other markets and observed the same pattern. Encouraging you to do your own testing based on our conclusion it would be interesting to use this indicator looking at the VIX contract and combine it as an intermarket analysis looking at the S&P500/VIX spread in combination with the efficiency ratio.