Dr. Alexander Elder cleverly named his first indicator "Elder Ray" by virtue of its function, which is 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 superficial glance at prices.
What Is The Elder-Ray Indicator?
Elder Ray is based on oscillators, labeling the 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.
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.
Interpreting the Elder Ray
In interpreting the 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 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.
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. The Elder Ray is an extremely accurate and effective means of identifying these opportunities.