The Elder-Ray Indicator: Seeing Into The Market

Dr. Elder cleverly named his first indicator “Elder-ray” by virtue of its function, which is figuratively similar to that of x-rays. 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 at a mere superficial glance at prices. Here we take a look at this indicator. (The main resource for this article is Elder’s book “Trading for a Living: Psychology, Trading Tactics, Money Management”.)

The Elder-Ray
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, 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 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 past 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:

1. The trend is up as indicated by EMA.
2. Bear Power is negative but rising.

There are two additional conditions fine-tune the buying decision:

1. Bull power’s latest peak is higher than it was previously.
2. 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:

1. The trend is down as indicated by EMA.
2. Bull power is positive but falling.

Two additional conditions provide a stronger signal for shorting, but they are not absolutely essential:

1. Bear power’s latest bottom is deeper than any previous bottom.
2. 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.

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.

Good luck with all of your trading endeavors!

by Jason Van Bergen, investopedia.com

Massive Hedge Fund Failures

The failure of a small hedge fund doesn’t come as a particular surprise to anyone in the financial services industry, but the meltdown of a multi-billion fund certainly attracts most people’s attention. When such a fund loses a staggering amount of money, say 20% or more in a matter of months, and sometimes weeks, the event is viewed as a disaster. Sure, the investors may have recovered 80% of their investments, but the issue at hand is simple: Most hedge funds are designed and sold on the premise that they will make a profit regardless of market conditions. Losses aren’t even a consideration – they are simply not supposed to happen. Losses that are of such magnitude that they trigger a flood of investor redemptions that force the fund to close are truly headline-grabbing anomalies. Here we take a closer look at some high-profile hedge fund meltdowns to help you become a well-informed investor.

Background
Hedge funds always have had a significant failure rate. Some strategies, such as managed futures, had an attrition rate as high as 14.4% per year between 1994 and 2003, according to a study recently released by the European Central Bank titled, “Hedge Funds And Their Implications For Financial Stability” (August 2005). It cannot be denied that failure is an accepted and understandable part of the process with the launch of speculative investments, but when large, popular funds are forced to close, there is a lesson for investors somewhere in the debacle.

While the following brief summaries won’t capture all of the nuances of hedge fund trading strategies, they will give you a simplified overview of the events leading to these spectacular failures and losses. Most of the hedge fund fatalities discussed here occurred in 2005 and were related to a strategy that involves the use of leverage and derivatives to trade securities that the trader does not actually own.

Options, futures, margin and other financial instruments can be used to create leverage. Let’s say you have $1,000 to invest. You could use the money to purchase 10 shares of a stock that trades at $100 per share. Or you could increase leverage by investing the $1,000 in five options contracts that would enable you to control, but not own, 500 shares of stock. If the stock’s price moves in the direction that you anticipated, leverage serves to multiply your gains. If the stock moves against you, the losses can be staggering.

Bailey Coates Cromwell Fund
In 2004, this event-driven, multistrategy fund based in London was honored by Eurohedge as Best New Equity Fund. In 2005, the fund was laid low by a series of bad bets on the movements of U.S. stocks, supposedly involving the shares of Morgan Stanley, Cablevision Systems, Gateway computers and LaBranche (a trader on the New York Stock Exchange). Poor decision making involving leveraged trades chopped 20% off of a $1.3-billion portfolio in a matter of months. Investors bolted for the doors and on June 20, 2005, the fund disolved.

Marin Capital
This high-flying California-based hedge fund attracted $1.7 billion in capital and put it to work using credit arbitrage and convertible arbitrage to make a large bet on General Motors. Credit arbitrage managers invest in debt. When a company is concerned that one of its customers may not be able to repay a loan, the company can protect itself against loss by transferring the credit risk to another party. In many cases, the other party is a hedge fund.

With convertible arbitrage, the fund manager purchases convertible bonds, which can be redeemed for shares of common stock, and shorts the underlying stock in the hope of making a profit on the price difference between the securities. Since the two securities normally trade at similar prices, convertible arbitrage is generally considered a relatively low-risk strategy. The exception occurs when the share price goes down substantially, which is exactly what happened at Marin Capital. When General Motors’ bonds were downgraded to junk status, the fund was crushed. On June 16, 2005, the fund’s management sent a letter to shareholders informing them that the fund would close due to a “lack of suitable investment opportunities”.

Aman Capital
Aman Capital was set up in 2003 by top derivatives traders at UBS, the largest bank in Europe. It was intended to become Singapore’s “flagship” in the hedge fund business, but leveraged trades in credit derivatives resulted in an estimated loss of hundreds of millions of dollars. The fund had only $242 million in assets remaining by March 2005. Investors continued to redeem assets, and the fund closed its doors in June 2005, issuing a statement published by London’s Financial Times that “the fund is no longer trading”. It also stated that whatever capital was left would be distributed to investors.

Tiger Funds
In 2000, Julian Robertson’s Tiger Management failed despite raising $6 billion in assets. A value investor, Robertson placed big bets on stocks through a strategy that involved buying what he believed to be the most promising stocks in the markets and short selling what he viewed as the worst stocks.

This strategy hit a brick wall during the bull market in technology. While Robertson shorted overpriced tech stocks that offered nothing but inflated price to earnings ratios and no sign of profits on the horizon, the greater fool theory prevailed and tech stocks continued to soar. Tiger Management suffered massive losses and a man once viewed as hedge fund royalty was unceremoniously dethroned.

Long-Term Capital Management
The most famous hedge fund collapse involved Long-Term Capital Management (LTCM). The fund was founded in 1994 by John Meriwether (of Salomon Brothers fame) and its principal players included two Nobel Memorial Prize-winning economists and a bevy of renowned financial services wizards. LTCM began trading with more than $1 billion of investor capital, attracting investors with the promise of an arbitrage strategy that could take advantage of temporary changes in market behavior and, theoretically, reduce the risk level to zero.

The strategy was quite successful from 1994 to 1998, but when the Russian financial markets entered a period of turmoil, LTCM made a big bet that the situation would quickly revert back to normal. LTCM was so sure this would happen that it used derivatives to take large, unhedged positions in the market, betting with money that it didn’t actually have available if the markets moved against it.

When Russia defaulted on its debt in August 1998, LTCM was holding a significant position in Russian government bonds (known by the acronym GKO). Despite the loss of hundreds of millions of dollars per day, LTCM’s computer models recommended that it hold its positions. When the losses approached $4 billion, the federal government of the United States feared that the imminent collapse of LTCM would precipitate a larger financial crisis and orchestrated a bailout to calm the markets. A $3.65-billion loan fund was created, which enabled LTCM to survive the market volatility and liquidate in an orderly manner in early 2000.

Conclusion
Despite these well-publicized failures, global hedge fund assets were still growing at a rate of 20% at the end of 2005, according to the International Monetary Fund. These funds continue to lure investors with the prospect of steady returns, even in bear markets. Some of them deliver as promised. Others at least provide diversification by offering an investment that doesn’t move in lockstep with the traditional financial markets. And, of course, there are some hedge funds that fail.

Hedge funds may have a unique allure and offer a variety of strategies, but wise investors treat hedge funds the same way they treat any other investment – they look before they leap. Careful investors don’t put all of their money into a single investment, and they pay attention to risk. If you are considering a hedge fund for your portfolio, conduct some research before you write a check, and don’t invest in something you don’t understand. Most of all, be wary of the hype: when an investment promises to deliver something that sounds too good to be true, let common sense prevail and avoid it. If the opportunity looks good and sounds reasonable, don’t let greed get the best of you. And finally, never put more into a speculative investment than you can comfortably afford to lose.

by Jim McWhinney, investopedia.com