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What is a golden cross and how to use it
Golden crosses, and death crosses, are some of the more familiar chart patterns for market watchers. In this article, get a deeper understanding on how a golden cross forms and how it can be used to spot market trends changes.
What is a golden cross?
A golden cross is the crossing of two moving averages, a technical pattern indicative of the likelihood for prices to take a bullish turn. Specifically, it is when a short-term moving average, which reflects recent prices, rises above a long-term moving average, which is also the longer-term trend. Therefore, this shows that prices are gaining bullish impetus and is more so the case when accompanied by high trading volumes. Vice versa, the opposite is the case for a death cross, such as when the short-term moving average slips below the long-term moving average.
Golden crosses, alongside death crosses, are popular indicators watched by market participants and gains traction with news headlines as well. This is largely attributed to the fact that this indicator is easy to follow, even though it may occur less frequently as an indication to take action as compared to other technical indicators. Commonly used moving averages are the 50-day moving average (DMA) and the 200-DMA for the short- and long-term moving averages respectively. Note that many do not use the golden cross as an indication in silo and usually combine this indicator with others such as the relative strength index (RSI) or moving average convergence divergence (MACD) indicators, easily called up on most charts.
Three stages of a golden cross
While the abovementioned crossing of moving averages sound reasonably intuitive, technical analysts would highlight that there are three stages to the golden cross.
- Firstly, prior to the crossing of the moving averages, there exists a downtrend which also corresponds to the phenomenon whereby the short-term moving average had been traversing below the long-term trend.
- In the second stage, which is also the intersection, a new trend emerges whereby the short-term moving average takes over the long-term moving average.
- Finally, there needs to be continuation where the uptrend sustains and the short-term DMA act as a support for prices.
An example can be seen below using Apple looking at a short-term 20-DMA and 100-DMA golden cross. Following the intersection in March 2019, prices were kept above its short-term DMA before a break below, suggesting a change in trend.
Profit potential of the golden cross pattern
Unlike various technical patterns, the profit potential for the golden cross pattern is unfortunately not typically spelt out clearly. The idea of using a golden cross as an indicator is to recognise the change of price trajectory into an uptrend and to trade this trend . This rally may last for a varying period. Other ways to recognise when the trend is ending, such as when the short-term DMA falls back below the long-term DMA, would help to recognize when to take profit.
How to trade the golden cross
Once again using Apple as an example, one can see that the 50-DMA had risen above the 200-DMA in late 2016, providing a bullish signal. As we have mentioned, other indicators are oftentimes used in conjunction to confirm the trend and, in this case, the MACD likewise exhibits this build up to the crossover point. One can therefore continue to trade this trend and exit when the 50-DMA sinks back below the 200-DMA such as in late 2018, although one may be wiser doing so earlier seeing that firm break of the 200-DMA earlier in the year.
Some may argue that a true golden cross occurs only with the 50-DMA and the 200-DMA such as the abovementioned example. However, this may only be due to the popularity of the two moving averages that reinforces them as an indication. Using the two, the opportunities to spot a change in trend may be few and far between and could be a relatively laggard indication as well, though longer term investing may find this a helpful indication to complement fundamental reasons for buying the stock.
On a shorter-term basis, this can apply to Apple’s four hour chart such as the below. One can enter into a buy position with the crossing of the short-term moving average above the long-term moving average and later proceed to exit at the reverse or even prior when prices itself fall below the long-term moving average. For high-frequency trading, the golden cross strategy or simply any strategy that utilises the crossover of moving averages can be implemented using algorithms for one’s trading system.
Validity of the golden cross
As with any technical indicator, the feasibility of working with a certain stock or asset class in general does not guarantee that it works with another. One key issue with the golden cross often discussed is the fact that it is a lagging indicator. Information of historical prices lack the predictive power to pre-empt future price movements. This is also the reason why it is frequently used hand-in-hand with other indicators or fundamental analysis to make a trading decision.
That said, back testing a golden cross trading strategy upon various asset classes can drive interesting results and one might just find this more applicable as a technical analysis tool.
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