We were searching for exit strategies for profit taking because very often, we learn of strategies which teach us when to enter a trade, but leave us guessing as to when to take profit. Perry Kaufman, in his book Smarter Trading, gives some interesting adaptations to trend-following methods. He says that trading in the direction of the trend is a safe, conservative approach to the markets. But trend following must be able to separate the trend from the random noise in the market. He developed the Efficiency Ratio for this purpose.
An “efficiency ratio” is calculated as 10-period price changes divided by the sum of 10 period closing price differences. The ratio gives the efficiency, or relative noise, of price movement over the 10 periods. It can also be considered a ratio of the price direction to its volatility. The more efficient, the faster the trend. The Efficiency Ratio has values ranging from 0, when markets are very noisy for the current amount of direction, to +1 when prices are highly directional.
Efficiency_Ratio = direction/volatility
By dividing the directionality by the noise, the ratio varies from 0 to 1. When the market moves in the same direction for all n-days, then direction equals volatility and Efficiency_Ratio = 1. If volatility increases for the same price move, volatility gets larger and the ratio ER moves away from 1. If prices go nowhere, then direction = 0 and ER = 0.
The smoother the market is trending the greater the Efficiency Ratio. Efficiency Ratio readings around zero indicate a lot of inefficiency and “choppiness” in the market movements. It is virtually impossible for an instrument to have a perfect efficiency ratio since any adverse movement against the prevailing trend direction during the time period being evaluated would decrease the efficiency ratio.
Kaufman comments that one should take profits whenever efficiency exceeds some predetermined level. He states that a high efficiency ratio cannot be sustained, so that it usually drops quickly once a high value is obtained. Kaufman’s exit signal is when the efficiency ratio hits a very high value such as 0.8; that’s usually when a strong trend is interrupted by market noise. Let’s look at this EURUSD example:
We see a strong downward trend taking the Efficiency Ratio to above 0.8 (above the top horizontal yellow line). As indicated by Kaufman, such “efficient” trends are usually short-lived and market noise will pull the ratio back below 0.8, which is what we see in this chart. As market noise took over, the down trend ended where the blue vertical line is.
Note however, that as we experimented this indicator on currency pairs, the trend can sometimes resume after the noise. The concept to takeaway from this article is that you can choose to take profit once the Efficiency Ratio hits a high value such as 0.8 – this is when noise will mark the end of the strong efficient trend. You may choose to re-enter the trade should the trend resume after the noise.
You can download the Kaufman Efficiency Ratio here. Give it a shot and let us know how it works for you!