Dr. Alexander Elder cleverly named his first indicator Elder ray because of its function, which is designed to see through the market like an X-ray machine. Developed in 1989, the Elder-ray indicator can be applied to the chart of any security and helps traders determine the strength of competing groups of bulls and bears by gazing under the surface of the markets for data that may not immediately be ascertainable from a superficial glance at prices.
What Is the Elder-Ray Indicator?
Elder-ray indicator or Elder-ray index has two key components (bull power and bear power) as well as exponential moving averages (EMAs), which are trend-following indicators essential to the calculation. Mathematically, bull power is derived by subtracting an exponential moving average (perhaps a 13-day EMA) of closing prices from a high price of any given security. Bear power subtracts the EMA from the corresponding low price of that trading day. Both bull power and bear power values are plotted as histograms under the bar chart of your chosen security.
- Alexander Elder created the Elder-ray indicator, which gets its name from the fact that it is designed to see through the market like an X-ray machine.
- Elder-ray indicator is plotted as two separate histograms at the bottom of a chart and computed as an exponential moving average minus the high and low of the day.
- The slope of the EMA gives insight into the recent trend: up or down.
- Divergences, such as when prices reach new highs but bull power does not, could send an early signal that a trend reversal is at hand.
Remember that price is a consensus among investors of value for any given security at a particular point in time. The moving average is simply a consensus of value that is extended for a certain window of time. The 13-day EMA referenced earlier is the average consensus of value over the last 13 days.
Interpreting Elder-Ray Indicator
In interpreting a moving average, traders are most concerned with its slope. When the slope rises, the crowd is becoming more bullish. When it falls, the crowd is more bearish. Clearly, the best course of action is to trade in the direction of the EMA.
The high of the consensus of value occurs when bulls cannot lift prices any higher, thereby reaching their maximum power. The low represents the lowest value to which the bears are capable of pushing the price, thereby reaching their maximum power.
By measuring the distance from the high price of the day to the EMA, bull power represents the capacity of bulls to push prices above the average consensus of value (price). Bull power rises when bulls are stronger and falls when they are weaker, even becoming negative when they are utterly weak.
Bear power, by contrast, is the capacity of bears to push prices below the moving average. The distance between the low and the EMA, which widens when the bears are weaker and narrows when they are stronger, gives this figure. Bear power is typically negative, so if it turns positive, the bulls have taken complete control.
Conditions When Using the Indicator
There are some specific conditions you need to look for when using the Elder Ray in making buying/selling and shorting/covering decisions.
- The trend is up, as indicated by EMA.
- Bear power is negative but rising.
There are two additional conditions that fine-tune the buying decision:
- Bull power's latest peak is higher than it was previously.
- Bear power is moving higher from a bullish divergence. This situation provides traders with the strongest buy signal.
The corresponding sell signal is realized when prices hit a new high, but bull power reaches a lower peak than that of its previous rally. For shorting, two conditions are absolutely necessary:
- The trend is down as indicated by EMA.
- Bull power is positive but falling.
Two additional conditions provide a stronger signal for shorting but they are not absolutely essential:
- Bear power's latest bottom is deeper than any previous bottom.
- Bull power is declining from a bearish divergence. As in the case of buying, the strongest signals for shorting are rendered by bearish divergences between bull power and prices.
In deciding when to cover short positions, it is important to interpret the time at which bear power indicates the weakness or strength of bears. A new low in price with a new low in bear power points to a continued downtrend; however, with bear power tracing a shallower bottom than prices, a bullish divergence is realized: cover your shorts and prepare for the ensuing uptrend.
The Bottom Line
Divergences between bull or bear power and prices indicate the best trading opportunities using the Elder-ray index. Equally important is the slope of the exponential moving average, as direction indicates the general trend. As with any technical indicator, Elder-ray is best used with other forms of fundamental or technical analysis and not as a standalone tool.