Efficiency Ratio

About Efficiency Ratio

The  ("") Efficiency Ratio (ER) is used in technical analysis to spot periods of strong and weak trends. Low Efficiency Ratio readings are an indication of a weak trend and high Efficiency Ratio readings are a sign of a strong trend.

One of the biggest question in technical analysis is how to recognize periods of side-way trending when it is preferable remaining in cash. In most cases, strong trends are short-lived and side-way trends are prolonged in time. We may have 5-day strong trend and then we may run into a month od a side-way trending. It would be very nice is we would not have these side-way periods, then, most of the technical indicators would work most of the time. Unfortunately, we do have them. Many trader lose all previously earned profit during these periods and many technical analysts attempted to find a tool which would allow to evaluate a strength of a trend to see whether it is worth reacting on generated trading signals.

The Efficiency Ratio is one of the technical indicators developed to evaluate the strength of a price trend. Also, there are other indicators like Vertical Horizontal Filter and Average Directional Movement Index Rating used to recognize strong trends. Number of Price Channels are could be used for this purpose as well.

The Efficiency Ratio is very simple in use. On the stock chart below you may see an example how this indicator may help you in spotting weak and strong trends. While it looks simple, there are two major problem you may run in when you start using this technical indicator:

• As most similar indicators, this indicator is quite choppy. You may increase bar period to make it smoother, yet, it will create a big lag.
• This indicator is not measured in absolute values. Therefore, there are no defined recommended trigger levels. You would need to scroll charts back in history for your stocks and for your timeframe to figure out the Efficiency Ratio levels which could be considered as an indication of a strong trend.