Earlier, I looked at Seven Quantifiable Ways to Define Trend; today I want to look more deeply at the Efficiency Concept.

The Efficiency Concept From point A to point B in time, the market has moved from price A to price B, and those prices may be the same (no net change in price) or very different (the market has doubled or even tripled). In the interim, the time between point A and point B, it’s highly likely that the market didn’t take a straight line movement from price A to price B. If we make some estimate of the total price movement in the interim, we can divide the endpoint measurement of price movement by the total to develop an “efficiency of movement” measure. This is the method used by the Thermostat Trading Strategy, which can be found in George Pruitt and John R. Hill’s “Building Winning Trading Systems with TradeStation.” They called their function “Choppy Market Index” and divided the absolute value of the 29-day change in price by the difference between the 30-day high and 30-day low price, then multiplied by 100 so that the range was from 0 to 100 instead of from 0 to 1. Their cutoff to define a trend was “20″ - below 20 and they traded counter-trend, above 20 and they traded in the direction of the trend.

Computationally, the ratio of endpoint-to-endpoint price change to the high minus low price between endpoints is simple and direct, and has only one parameter, the unit of time elapsed between endpoints. Unfortunately, this method has a drawback, if we’re thinking about using it as the criterion for a regime-switching trading system.

Imagine a price goes from 100 to 110 over some unit of time, with a high and low of 120 and 90, respectively. This is a “Choppy Market Index” of 33.33 and suggests a trend-following technique according to the quoted methodology. If the price hits that high and low only once each, that’s one thing; but if the price hits that high and low TWICE each, or even more often, then that’s a horse of a different color. Perhaps it’s best illustrated graphically (click the chart for better resolution).

Believe it or not, all three of those charts have the SAME “Choppy Market Index” of 33.33.

I can think of at least two other ways to define the efficiency concept, both of which take better account of the movement between endpoints, but neither of which are as computationally simple as their “Choppy Market Index.”

The most robust method would be to compile the True Range (a measure which includes the gaps between days) of the issue for the entire time period, and use that as the denominator instead of the difference between high and low. The link explains the “Average True Range” (ATR) indicator, but to get the total movement, you’d want to sum the true range for each day or multiple the ATR by the number of days - just keep in mind that StockCharts.com uses an exponential moving average on the ATR, and not a simple moving average.

A method that didn’t take into account the intraday volatility might be more appropriate if using end of day data to trade; in that case, one could simply sum the absolute values of the changes over each day’s close, and use that as the denominator instead of the high-low difference.

If we took the method which summed up the absolute values of daily movements, the above graph would have shown “Efficiency” measurements of 20.00, 9.09, and 5.88, respectively, instead of the same 33.33 for each chart. It’s pretty obvious that “efficiency of trend” deserves a more detailed look than the one given it by the Thermostat Trading Strategy.

There’s one last detail to keep in mind, and this is one that’s often forgotten by pundits and traders alike; stocks and the stock indices have a strong upward bias over time. This often manifests itself in a strong negative move (for stocks or the stock indices) leading, not to a continuation of trend, but to a reversal over the same timeframe. The Thermostat Trading Strategy was designed to be traded against a basket of commodity futures, and since those don’t tend to have the same (or as strong a) persistant upward bias as stocks do, taking long and short signals makes sense - THERE. But not necessarily so in stocks … people who take technical analysis-based long strategies for stocks and simply “flip them” short are potentially risking their accounts. Better to check those assumptions about symmetry before putting money on them!

If I were to use the Efficiency Concept to devise a regime-switching trading system, my next step would be to broadly analyze the average movement of my trading issue (stocks, futures, whatever) at different levels and parameters (measurement lengths) of “efficient trends,” and then test different assumptions about what works, and where.

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