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The Efficiency Ratio is an indicator that lets you quantify the directionality of a market using values ranging from 1 to 100.
Its purpose is to measure how "efficient" the trends of a market are.
This video shows how to use the efficiency ratio to build a basic trading system that uses the information provided by this indicator as entry signals.
And to verify the effectiveness of this strategy, we decided to test it on one of the most directional markets ever: cryptocurrencies.
By watching this video, you'll learn:
- What is the efficiency ratio, and how to calculate it
- How to use it to build a basic trading system
- The results you can get by applying this system to cryptocurrencies
Hey everyone and welcome to this brand-new video about trading!
Today we're going to be talking about a less known but extremely interesting trading indicator called the efficiency ratio.
I'm one of the coaches of Unger Academy.
Let's start our video!
What Is the Efficiency Ratio?
First of all, what is the efficiency ratio? As you probably know, it's an indicator whose purpose is basically to quantify the directionality of a market trend using numbers. But let me explain this more clearly.
This is how the efficiency ratio is calculated. In the numerator, there's the price change as a positive number, an absolute value.
Now suppose we want to calculate the efficiency ratio from this bar to the last bar of the chart. We'll take the close of the last bar and subtract from it the close of the first bar. We'll then divide this number by the sum of all the ranges, or rather, all the true ranges of the following bars up to the last bar of the chart.
Why? Because to go from the first close we're considering to the current close, this underlying has gone through a whole series of fluctuations. There have been real market movements that led to the current point. So what we want to do with this indicator is understand how efficient the underlying has been while it was moving towards this point. Did it reach it in a linear and straightforward way, or did it go through a lot of fluctuations and get there in an inefficient way?
Now that we have understood the logic behind the efficiency ratio, we can say that, in a sense, it does something quite similar to what is done by the more famous ADX indicator. It measures the directionality of an underlying and, like ADX, it's usually represented by a number that goes from 0 to 100 - with zero meaning no directionality at all and 100 meaning maximum directionality.
The Efficiency Ratio and Bitcoin
This is the chart of Bitcoin, and we have applied the efficiency ratio to it. As you can see, when the market doesn't behave in a strongly directional way, as it happens in these bars, the efficiency ratio tends to drop and then starts to rise again in the presence of some strong movements. Obviously, like all indicators, it does have a certain delay. In this case, we calculated the efficiency ratio considering 15 bars.
This indicator can certainly be useful in building trading systems. How, you might ask? Well, its most obvious use is as an operating filter. For example, we can use it to allow a trading system to work only when the market is strongly directional. Or we can use it in breakout strategies where we wait for an absence of directionality to place the stop orders on certain levels that could be identified, for example, using the highs or the lows of the previous bars. So the efficiency ratio can really be an interesting operational filter.
However, today I want to show you something different. I leave it to you to test this indicator as an operating filter, and I'm going to show you how to use the efficiency ratio as an entry signal. To do this, we obviously need to work on an underlying that is strongly directional, so what could be better than a cryptocurrency to try this kind of setup?
The Starter Script
So let's take our script based on the efficiency ratio. Now please note that, in reality, this isn't a trading system yet because it's still incomplete. However, I want to show it to you because it can really be a good starter script that you could use to build a good trading system.
Condition number one requires that the efficiency ratio is higher than a trigger. By default, I set it to 50 and, if the condition is true, and 'c' (which is the current close) is greater than the close of the last 'N' bars (and here we use the same value we used to calculate the efficiency ratio) then the system goes long at the close of the bar. When do we close the trades? At the end of the day, if there's no exit condition.
As you can see, this is a very simple script. It's still very basic, and there are no risk management rules in it yet, so please don't take it and use it as it is! However, it's a good starter script that you can use to develop a trading system for cryptocurrencies.
It only opens long positions because due to the bias that exists on cryptocurrencies, it's quite difficult to trade these markets with short positions. So let's go and apply this basic system to Bitcoin and see what happens.
But first, let's take a look at the inputs that we are using. We use 10 as a value for calculating the efficiency ratio and 40 as an entry trigger.
Now let's check out how the equity line looks. You see, it's not bad at all! Especially if we consider that we haven't even optimized the inputs yet.
The average trade is not very large. It's about $55. Since we're using a capital of $10,000, this means 0.55% of the trade size. Anyway, this starter script is absolutely interesting and can already cover the operating costs, although not in an optimal way.
Now, there's an interesting thing I'd like to show you. Let's take a look at the buy and hold of Bitcoin. As you know, in recent years, Bitcoin has had some very strong volatility explosions. It's grown a lot, but we can also see that it has had some truly remarkable drawdowns.
And what's interesting is that by applying this trading system based on the efficiency ratio, we can manage to avoid most of these drawdowns. We can, in fact, reduce the drawdown to more bearable levels and still make a profit of $27,500 using a capital of just $10,000 over about three years.
Backtest Results on ETH and ADA
At this point, you may be wondering how this basic system performs on a different underlying. So let's test it on another market. Let's pick another cryptocurrency and see what happens.
Ok, let's take ETHUSDT and check out the results. We can expect a rising equity line here too.
And then let's pick yet another crypto. For example, we can take ADAUSDT.
Now let's arrange the windows in such a way that we can see all the charts and wait for the backfilling of the data, and see the results that we get on these other two cryptocurrencies.
Ok, so the equity line on Ethereum is quite good, I think anyway. Let's check out the average trade: it's about the same size. Okay.
Now let's focus on the results we get on ADA. The equity line is quite good too. And if we look at the average trade, we see that it's even a bit larger in this case.
Note that we have chosen these two cryptocurrencies totally at random. This is something that can certainly reassure us because we have chosen three underlyings at random, and we got these good results without even optimizing any inputs.
So, why don't you start to trade cryptocurrencies? You could develop this starter script and build something more sophisticated, a trading system that includes risk management rules, which are missing in this basic system.
How can you do that? For example, you could use the patterns of the Unger Method to filter the trades even further, since we have just seen that this entry setup generates several trades.
If you want to learn more about the Unger Method, which is the method of the only 4-time world trading champion with real money, we're going to leave you a link in the description of this video.
It'll take you to a video where Andrea explains a lot of what he's learned in over 20 years of first-hand experience as a trader, and I'm sure that if you're interested in systematic trading, you're going to like this video.
With that goodbye, everyone, I will see you in our next video! Until then, please stay safe! Bye-bye!
Need More Help? Book Your FREE Strategy Session With Our Team Today!
We’ll help you map out a plan to fix the problems in your trading and get you to the next level. Answer a few questions on our application and then choose a time that works for you.BOOK YOUR FREE STRATEGY SESSION NOW >>
Hi, I'm Francesco Placci, a professional trader since 2005 thanks to the systematic approach to the markets.
My skills range from trading on index futures to bonds, from stocks to commodities, with a particular focus on volatility and options, which I consider to be among the most versatile and fascinating instruments available to traders.
After an experience with leading Italian credit institutions where I learned the basics of institutional finance, I became a successful independent trader, with great personal satisfaction.
Founder of Algoritmica.pro, in 2019 I joined Unger Academy as head of Research and Development.