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If the Efficiency Ratio is low,
then a mean-reverting strategy is
better than a trend method.
Kaufman: Absolutely. Trends in general are what I call a
“sound premise.” But they need to be long-term trends to
pick up the direction of the economy, or the US dollar or
euro, or major changes in supply and demand. I wouldn’t
try faster trends because I don’t think they’re reliable.
Prices can jump quite a bit on news, but it’s hard to
capture that with a moving average, and most often you
get false signals. Trend systems need to capture the fat
tail to be successful. If you’ve studied the profile of trend
performance, there are many more losses than profits, so
the profits need to be bigger. I’m convinced that you need
the rare, very large profit to win on balance.
TRADERS´: What do you think about genetic programming
Do you have experience in this field, and if so, which
results did you attain
Kaufman: I’ve created a portfolio program using a genetic
algorithm, and I think I can beat the standard meanvariance
approach that is used in the industry. On the
other hand, I wouldn’t use either one because they are
simply an exercise in over-fitting. These powerful tools
are tempting, but I don’t think they work in the markets.
And I haven’t read anywhere that they have predictive
power. I still think the best solutions are simpler ones.
TRADERS´: Young markets and old markets … this topic
was originally addressed in your “Smarter Trading” book.
Nowadays, which are the younger easier markets and
which one the older
Kaufman: That’s a good question and it goes back to why
the smaller investor has an advantage. Newer markets,
usually index markets, are much trendier and can be
traded with faster moving averages, or whatever trending
method you want. It’s the same as the way we traded
in the 1970s before volume jumped up. New markets
don’t have as much noise because there are far fewer
participants. As they mature they get noisier, so the US
index markets, followed by European, are the noisiest
and need slower trends to be successful. So there is a
window of opportunity for the retail trader to use a trend
for new index markets.
TRADERS´: What is the most reliable technical indicator in
order to detect noise in a price series
Kaufman: The only one I know that measures noise is
my own “Efficiency Ratio,” which has also been named
“fractal efficiency.” It’s simply the difference in price over
n days divided by the sum of the path, which is the sum
of absolute values of the daily changes over the same
n days. The idea was that if you went in a straight line
from point A to point B, then the efficiency was 1.0 (no
noise). If you wander around then the efficiency goes
down, and if you go nowhere then the efficiency is zero
(all noise). Even though I did that in the early 1980s, the
only useful application that I’ve found is for it is deciding
which system to apply to each market. For example, if the
ratio is high then there is a lot of trend and we can use a
trend method. If the ratio is low, then a mean-reverting
strategy is better. I was hoping for more but haven’t yet
figured it out.
I have two charts that I created for the Asian Financial
Forum in 2012. One chart ranks the Asian markets by
noise (Figure 2) and the other ranks a large number of
futures markets the same way (Figure 3). You’ll see that
the more mature Asian markets, the ones in Japan and
Hong Kong, are the noisiest while the less traded ones,
Sri Lanka and Vietnam, are the trendiest. And for futures,
the U.S. and European index markets are the noisiest if
you look past the agricultural products (seasonality fights
with the long term trend). So you want to favour mean
reversion systems for those markets on the right of the
chart, and trend systems for those on the left.
TRADERS´: From your experience, what seems to be the
best filter ever for detecting a trend
Kaufman: I would use a long-term trend as a filter for
short-term trading. And it doesn’t really matter which
method you use. I think that most trend calculations
give you the same result over time. It’s really the market
and not the method. If the market is trending then all
the methods are profitable, and if it’s not trending then
none of them are. There are some internal differences.
For example, a moving average has a lot of small losses
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