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A Guide to Creating A Successful Algorithmic Trading Strategy by Perry J. Kaufman

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CHAPTER 15 Matching the Strategy to the Market

Much earlier in this book, I referred to the efficiency ratio as a way of measuring price noise. In turn, lower noise means that prices are moving smoothly. “Smoothly” does not say anything about the volatility, only that the price is going consistently in one direction. When the direction changes, it goes consistently in the new direction. Low noise is good for trend following; high noise is good for mean reversion. In this chapter, we look at how some of the markets are ranked. In that way, you can decide which markets are more likely to be successful with your strategy.

We can define the efficiency ratio as the net change in price over n days divided by the sum of the absolute changes over the same period. Then, if the market goes from one price to another in a straight line, it is highly efficient (actually, perfectly efficient) and best exploited with a directional approach, such as trend following. If prices move up and down, much like a drunken sailor’s walk, it is inefficient, the ratio is low, and a mean reversion approach is best.

Applying the efficiency ratio to futures, and even ETFs, is more accurate than applying it to individual stocks. A single stock can change its character based on news, the resignation of the CEO, an announcement that they’ve lost a lot of money in a foreign exchange hedge, or other unique events, but an index or highly liquid futures market maintains the same type of price movements for long ...

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