Let’s create an indicator of Perry Kaufman from his book “Trading Systems and Methods“.
In this book, the author shows a systematic approach with detailed explanations of each technique.
There are many interesting ideas in this book. Today we would like to create the Efficiency Ratio Indicator.
So, we will code his method to calculate the trend.
This indicator shows the actual existence of a trend.
If a stock has an Efficiency Ratio close to 1, means that the trend is strong.
When the indicator is nearing 1, we should use only trend follower strategies.
In short, use this indicator as a noise detector for your systematic trading. When the noise is higher, the trend is weak.
The more mature the market is, the more noise there will be.
We like to use this indicator in weekly charts. As you can see, it’s like an oscillator that increases when the trend is strong.
Perry Kaufman Trend Trading with Efficiency Ratio Indicator Evolved
It’s time to dress up the Perry Kaufman Trend Trading indicator. In fact, we could insert and show direction.
First, we have to calculate the stock’s direction using a simple method: two moving averages of 10 and 40 periods.
When the Fast Moving Average is above the Slow Moving Average the Trend is Up and vice-versa.
Secondly, we calculate two moving average of the Efficiency Ratio using 3 and 20 periods MA.
Why the moving averages?
We are using the Moving Averages because they are the easiest way to calculate the direction of one stock.
This MA crossover strategy is the base of many simple trend strategies. Generally, newbie traders start with this technique. In this case, we don’t average only the price, but we average also the indicator’s value.
When the faster Moving Average on the Close Price (10 periods) crosses and stays above the slower MA (40 periods) the trend is UP and vice-versa.
If the faster Moving Average on the Kaufman Indicator (3 periods) crosses and stays above the slower MA (20 periods) and the trend is UP, the color becomes Green.
When the faster Moving Average on the Kaufman Indicator (3 periods) crosses and stays under the slower MA (20 periods) and the trend is DOWN, the color becomes Red.
This indicator works very well, for example during the 2007-2008 financial crisis it filtered good and stayed flat.
Every time you make your trading decisions you must consider the trend. Remember that the trends exist only in higher time frames.
Consequently, we will use this indicator only on daily and weekly charts. It’s very important to use high value for slow Moving Average (min 40).
In the shorter time-frame, the noise is too high and you can’t find a real trend to trade. When the noise is high, you have to use only mean-reverting strategies.
We can use it as a trend filter for futures markets, stocks, and forex.
We like to use it, as a rule, to stop trading activity or to change the strategy. Remember, first of all, that you have to ask yourself if there is a condition for using a trend-follower strategy.
If we use a mean-reverting strategy, we would like to have an indicator near the 0 value. On the other hand, if the indicator is near the 1 value, we should use only trend follower strategies.
Kama Kaufman Moving Average Link
Editors’ Recommendations for Trading Strategies:
WIKIPEDIA: Perry Kaufman