Last Updated on April 19, 2022 by Quantified Trading
In a series of articles, we want to test different indicators and trading techniques. Almost all indicators are “proved” by anecdotal evidence, and rarely quantified. That’s perhaps not a coincidence: Most of them are useless and do not have any predictive value. We backtest some Elder Ray strategies and Our aim is to figure out if the indicator has any value at all.
This article explains the Elder Ray Indicator, how to use it as a trading strategy, and how it performs quantitatively. We conclude The Elder Ray indicator is an easy-to-understand indicator, but unfortunately doesn’t show reliability or profitability to make it worthwhile for developing trading strategies.
Why do we start with the Elder Ray Indicator – not exactly the most known or used indicator? It’s more of an emotional issue. Back in 1998, I ordered my first book through Amazon: Alexander Elder’s Trading For A Living. It’s a pretty standard trading book, but it holds a special place in my library because of sentimentality.
The Elder Ray Indicator explained
Elder Ray was developed by Mr. Elder in 1989 and named after its similarity to X-rays. On page 220 in his book Elder writes:
Doctors use X-rays to see bone structure below the surface of the skin. Traders can use Elder Ray to see the power of bulls and bears below the surface of the markets. To be a successful trader, you don’t have to forecast the future. You need to find when bulls or bears are in control and trade with the dominant group. Elder Ray helps you see when bulls and bears become stronger or weaker.
Mr. Elder sounds pretty pretentious by comparing X-rays to some simple moving averages (see the formula below). As usual, Elder doesn’t back up his statements with any tests whatsoever, except the usual anecdotal evidence by throwing in some random charts to show how useful the indicator is.
The Elder Ray Indicator can be labeled as a trend-following indicator. It consists of three different calculations:
- A 13-day exponential moving average (EMA).
- The Bull Power indicator: Current high – EMA.
- The Bear Power indicator: Current low – EMA.
The EMA defines the trend, while Bull and Bear Power are oscillators. Bull Power reflects the ability of bulls to lift prices above the average consensus of value. It measures the distance from the bar’s high to the EMA. Bull Power is normally positive.
Bear Power reflects the ability of bears to push prices below the average consensus of value. Bear Power measures the distance from the bar’s low to the EMA. Bull Power is normally negative.
This is an example of how it looks like (in Amibroker):
How do you use the Elder Ray Indicator?
According to Mr. Elder, there are two essential conditions for buying in an Elder Ray strategy:
- The trend is up (identified by EMA or a weekly trend-following indicator).
- Bear Power is negative but rising.
The third and fourth conditions are desirable but not essential:
- The latest peak in Bull Power is higher than the previous peak.
- Bear Power is rising from a bullish divergence.
Don’t buy when Bear Power is positive. Elder explains:
If you buy when bears are being held up in the air, you are betting on the greater fool theory. The best time to buy is when Bear Power is negative but rising.
Shorting can be done when opposite signals from buying occur:
- The trend is down (identified by EMA or a weekly trend-following indicator).
- Bull Power is positive but falling.
The third and fourth conditions are desirable but not essential:
- The latest bottom in Bear Power is deeper than its previous bottom.
- Bull Power is falling from a bearish divergence.
When do you sell a long position and when do you cover a short position? Elder is vague: when bulls start losing power is not a clear exit signal. We need strict criteria for the exit. The most logical exit signal is when Elder recommends to short. Opposite short is covered when a buy signal occurs. This means you are always in the market, either long or short.
Does the Elder Indicator work? Let’s quantify:
As with any indicator you have to quantify. How does the Elder Indicator perform?
Let’s test an Elder Ray strategy in Amibroker and see how it performs mechanically. The code is like this for long positions:
Buy= ElderEMA>Ref(ElderEMA,-1) AND BearPower<0 AND BearPower>Ref(BearPower,-1) ;
Sell= ElderEMA<Ref(ElderEMA,-1) AND BullPower>0 AND BullPower<Ref(BullPower,-1);
We enter on the close on the same day as we get the entry signal, and we exit on the close the same day we get the exit signal. The Elder Ray strategy was tested on many assets, mostly ETFs, and the results were mixed. The best result was in the S&P 500 (SPY). The second best was Gold (GLD).
The equity curve for SPY looks like this:
100 000 invested at the start of the year 2000 compounds to 209 000 by mid-2020, a CAGR of 3.6%. The strategy is invested 59% of the time. This compares to the “buy and hold” of 6.25% annually. The profit factor is a modest 1.5.
As the indicator is a trend-following indicator, it has few winners and many losers: the win-ratio is only 39.5%, much lower than mean-reverting strategies. The Elder Ray is profitable because the average winner is much bigger than the average loser: 3.3% vs. 1.54%.
The strategy has a maximum of 5 consecutive losing trades. After 5 straight losers, we are pretty sure that a lot of traders abandon this strategy. This is precisely why trend-following is so difficult, and perhaps why it continues to work.
We have no idea why Mr. Elder suggests to use a 13-day EMA. If we run other EMAs we get these results:
How does short perform? As expected, short gives very poor results. It produces losses in a wide array of ETFs. Short is really difficult in most asset classes.
We have written about Amibroker and its pros and cons compared to Tradestation, Multicharts and Ninjatrader:
When do you sell?
Alexander Elder recommends selling when bulls start losing power. This is of course gibberish and quite typical of “gurus”. In the above example, we used the signal for short as a sell criterion.
How does Elder Ray perform with another exit? We tried a dozen other sell criteria, but none managed to improve the original one.
Conclusion about the Elder Ray indicator:
The Elder Ray Indicator is not likely to be very successful on stocks and stock indices, nor does it show much promise on other asset classes. It’s unlikely to be very successful on stocks because of the mean-reverting tendencies in the stock market. However, when Elder invented the indicator in 1989 the markets were less mean-reverting.
Our conclusion is that the Elder Ray Indicator is not very useful.