Last Updated on 21 September, 2020 by Samuelsson
Named after Dr. Alexander Elder who developed it, the Elder Ray Index Indicator was designed in 1989 to see through the market, just the same way an X-ray machine sees through an object. But do you know how to use it?
The Elder Ray Index is quite easy to use once you understand how to read the various components. With the indicator, you can gauge the strength of the bulls and bears so as to predict the most likely direction the price may move next.
In this post, we’ll discuss what the Elder Ray Index is, how to read it, the psychology behind it, how to set it up on your chart, the ways to use it in your trading, the limitations, and how it’s different from the Elder Force Index.
What is the Elder Ray Index?
The Elder Ray Index is a technical analysis indicator created by a renowned trading psychologist and trader, Dr. Alexander Elder, to measure the competing buying and selling power in a financial market so as to determine the group driving the market at that moment. It is a trend-following indicator that also tells you when to open and close your trades.
It consists of three separately plotted indicators:
- An n-period exponential moving average (EMA)
- The bull power indicator
- The bear power indicator
The EMA is often plotted on the price chart as a separate component of the index, but it is also used in calculating the bull power and bear power components of the index. By default, the EMA is a 13-period exponential moving average of the closing prices, but you can use any period. What matters is that you use the same period for the bull power and bear power components.
What is the bull power indicator?
The bull power indicator component of the Elder Ray Index shows the relation between the day’s high price and the n-period EMA. It checks whether the day’s high is above or below the EMA and whether the difference between them. The bull power is calculated by subtracting the EMA from the day’s high, and the formula is given as:
Bull Power = Current High – 13-Period EMA (Close)
This indicator is plotted separately in the indicator box, and it appears as a histogram.
What is bear power?
The bear power is the third indicator in the Elder Ray Index, and it shows the relation between the day’s low and the n-period EMA. It checks the position of the day’s low when compared with the EMA and measures the distance between them. To get the bear power, you subtract the EMA from the low price of that trading day. As with the bull power, the bear power is plotted as a histogram in a separate indicator box.
Mathematically, the formula is given as:
Bear Power = Current Low – 13 Period EMA (Close)
How do you read the Elder Ray indicator?
To get the full picture of the market situation, you need to read all three components simultaneously. For the EMA, you consider the slope as it can show the direction of the trend. Since the bull power and bear power are plotted as histograms, you consider the position of the histograms relative to the zero line and whether they are increasing or reducing.
Another thing to consider about the bull and bear power histograms is a divergence from the price. A divergence is said to occur when the histograms and the price swings are not making similar highs or lows. There is a bullish divergence if the bear power histogram is making a higher low when the price is making a lower low. A bearish divergence occurs when the bull power makes a lower high when the price makes a higher high.
Putting them all together, here is how to read the Elder Ray Index:
- There may be a buying opportunity if:
- The EMA is sloping upward, indicating that the trend is up
- The bear power histogram is negative (below the zero line) but rising
- The bull power histogram is rising (getting more bullish)
Additionally, the setup is considered stronger if there is a bullish divergence in the bear power histogram. That is, if the bear power makes a higher low when the price makes a lower low, you have a better buy setup.
- There may be a selling opportunity if:
- The EMA is sloping downward, indicating a possible downtrend
- The bull power histogram is below is positive (above the zero line) but falling
- The bear power histogram is falling (getting more bearish)
Furthermore, if there is a bearish divergence in the bull power histogram, the sell setup is very strong. In other words, if the bull power makes a lower high when the price is making a higher swing high, there is a really strong sell setup.
The psychology behind the Elder Ray Index
The price of any security is a reflection of the market participant’s sentiments, especially fear and greed, which is what the Elder Ray Index tries to show. The indicator assumes that during an up-move, buyers get more greed and keeps buying closer to the highs while during a down-move, the bears get more afraid the lower the price falls and keep selling closer to lows.
By comparing the day’s high price to the n-period EMA, the bull power indicator shows the ability of bulls to push prices higher than the average. Hence, when the bulls are dominating, the bull power indicator rises, and when the bulls are losing momentum, the bull power indicator falls and can fall below the zero line.
On the other hand, the bear power indicator shows the ability of bears to push prices below the moving average. When the bears are weaker, the gap between the day’s low and the EMA widens, and when they are stronger, the gap narrows and can even become positive if the bulls have completely taken control.
How to set up the Elder Ray Index
As we said above, the Elder Ray Index consists of 3 separate indicators, so when you want to set up the index on your chart, you have to load the indicators one after another. You can start by attaching the EMA to your chart and setting the period to the number you prefer.
Then, search for the Elder Ray Bull Power Indicator and attach it to the chart. It will appear on the indicator window of your chart. Next, search and attach the Bear Power Indicator on the chart. This will take another indicator box on your chart below the one for the Bull Power. Make sure that they all have the same period length.
Trading with the Elder Ray Index
When using the Elder Ray Index to look for entry and exit points, there are different ways you can follow. You can go long if the EMA is sloping upward, the bear power histogram is below the zero line but rising, and the bull power histogram is rising, as you can see in the US100 chart below. Your exit can be when the bull power starts declining.
An alternative entry strategy for a long position is to look for a bullish divergence in the bear power indicator, which can be in the form of a lower low in the indicator and a higher swing low in price. See the chart below. A bearish divergence was a sign to exit.
For a selling setup, you can go short if the EMA turns downwards, the bull power histogram is above the zero line but declining, and the bear power histogram is falling. See the chart below. Note the potential exit point when the bull power histogram started rising.
Alternatively, you can go short when there is a bearish divergence in the bull power indicator. The divergence can be a higher swing high in price and a lower high in the bull power histogram or a lower swing high in price and a higher high in the bull power histogram as you can see in the chart below.
What are the limitations of the Elder Ray Index?
One of the main limitations of the Elder-Ray Index is that the EMA component can lag the price action by a lot since it is derived from historical price data. So, it doesn’t respond quickly to a sudden change in the price direction. By the time the indicator shows a signal, the price must have moved significantly, making it difficult to find a good spot for your stop loss order.
Another limitation is that the bull and bear power components can whipsaw quite a lot as they oscillate about the zero line. It is better to wait for a divergence signal or confirm with the EMA before making any trade.
What is Elder Force Index and how is it different from Elder Ray Index?
Another indicator created by Dr. Alexander Elder, the Elder Force Index should not be confused with the Elder Ray Index. While the Elder Ray Index tries to estimate the bull and bear powers at any point in a market, the force index measures the amount of force behind a price move.
The force index uses price and volume data in its calculations, and its values freely oscillate between positive and negative territories. It can be used to confirm trends and breakouts, as well as identifying potential reversal points using divergences. Traders use it to gauge the effects of volume on price movements. So, it is not only calculated differently from the Elder Ray Index but also tells a different story about the market.
The Elder Ray Index is a very useful indicator analyzing the markets and spotting trading opportunities. It has three components and can show both the direction of the trend and potential price reversal points.