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The Efficiency Ratio (ER) was initially described by Perry Kaufman in his book Smarter Trading. This same indicator also became known as Fractal Efficiency.
This ratio measure the efficiency of a trend by dividing the net price movement over a certain time period by the sum of the absolute values of the individual moves.
The value of the ER ranges between 0 and 1. It has the value of 1 when prices move in the same direction for the full time over which the indicator is calculated, e.g. n bars period. It has a value of 0 when prices are unchanged over the n periods. When prices move in wide swings within the interval, the sum of the denominator becomes very large compared to the numerator and ER approaches zero.
Some uses for ER:
- A qualifier for a trend following trade; a trend is considered "persistent" only when RE is above a certain value, e.g. 0.3 or 0.4 .
- A filter to screen out choppy stocks, where breakouts are frequently "fakeouts".
- In an adaptive trading system, helping to determine whether to apply a trend following algorithm or a mean reversion algorithm.
- It is used in the calculation of Kaufman's Adaptive Moving Average (KAMA).
In this implementation (indicator name S_Efficiency_Ratio() ) I have used Kaufman's formula where the ratio has the absolute value of the period price movement in the numerator, and it indicates only the efficiency, not the direction. Some other implementations do not use the absolute value, and the indicator value will be between -1 and +1 .