Dr. Alexander Elder cleverly named his first indicator "Elder-ray" by virtue of its function, which is figuratively similar to that of an X-ray. Developed in 1989, the Elder-ray helps 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 by a mere superficial glance at prices. Here we take a closer look at this indicator.
Understanding the Elder-ray is inextricably linked to an understanding of oscillators, which are figures used to find turning points in the markets. Oscillators are seen to be indicative of the emotional extremes of both bulls and bears. These extremes are fleeting and unsustainable levels of optimism or pessimism that the vast majority of market participants are exhibiting. Knowing that these extreme conditions never last long, professional traders often fare better than average investors in betting against such extremes. When the market rises and the bulls are greediest, the pros sell short. When the market is at its lowest and fear runs rampant, the pros jump in to buy.
Elder-ray labels its oscillator components as "bull power" or "bear power." These are combined with an exponential moving average (EMA), which is a trend-following indicator essential to the calculation. Bull power is a simple calculation, 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 are plotted as histograms under the bar chart of your chosen security.
Interpreting the Elder-Ray
Now, how do we go about interpreting the Elder-ray and its inherent components? First, you may remember that price is a consensus 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.
In interpreting the moving average, we 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. And the low represents the lowest value to which the bears are capable of pushing the price, thereby reaching their maximum power. So the low shown on the daily bar is the maximum power of bears for the day; on the weekly bar is their maximum power during the week, and so forth.
By measuring the distance from the bar's high 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.
There are some very specific conditions you need to look for when using the Elder-ray in making buying/selling and shorting/covering decisions. Here are the conditions essential for buying:
- The trend is up as indicated by EMA.
- Bear power is negative but rising.
There are two additional conditions 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 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. The Elder-ray is an extremely accurate and effective means of identifying these opportunities.