Catching The Trend : The Crossover Way

Identifying the trend of the market is the key to successful trading and the two crossovers – the Golden Cross and the Death Cross – provide vital signals to the trader about the impending movement of the market  Karan Bhojwani explains:

We all know trading is a great way to make a living and creating large wealth. Similarly, we have read the fact that over 90 per cent of traders fail to achieve success in the game of trading. So the question then arises: what does it take to become a successful trader? The answer is simple and we have heard it in various shapes and forms, but overall the theme is the same: “The trend is your friend.” Therefore, to become a successful trader, you need to catch the trend. However, there is a problem that most traders fail to understand and that is, most of the time the market does not move in trends. The market only trends only 30-40 per cent of the time, and rest of the time the market remains sideways or it does not have a discernable trend from which traders can make money.

Technical analysis offers various tools, techniques and studies to identify the trend. However, of all the technical analysis tools available to a trader, moving average lines are the simplest. Yet, that simplicity makes them powerful tool for interpreting and using them to identify the trend.

A moving average line is simply the average closing price of a stock or index over a set period of days (or a set number of bars, for traders using intraday charts). Each new bar leads to new calculation of a moving average line’s value, and as such, moving averages tend to follow.

In this special report, we take a look at the basic elements of one of the popular strategies used for trend trading known as the ‘Golden Cross’.

What is the ‘Golden Cross’:

The Golden Cross is a very popular trading concept used for generating trading signals. The signals are generated when a short term moving average crosses over a long term moving average. The Golden Cross typically refers to the crossing of the 50 and 200-Day Simple Moving Averages.  This is seen as bullish. Usually, a Golden Cross is associated with sharp upward price movement and can be used as a buy signal in the belief that a significant uptrend will follow.

In order to fully understand a Golden Cross, it is important to understand the fundamental concept of moving average, which is a key element for this trading strategy.

Moving Average Explanation:

The moving average consists of a line which smoothens price action by taking the average closing price over “X” periods. This “X” period is number of bars or candlestick.

If the moving average is over 5-period, it will take closing prices of the previous 5 candles in order to give you an average value for the current period.

Let’s now take a look at a basic example for performing the calculation of a 5-period moving average:

• Rs 100
• Rs 120
• Rs 125
• Rs 132
• Rs 140

If you have these 5 closing prices of a stock, then a simple moving average will give you the following average value on the opening of the 6^th Day:

(100+120+125+132+150)/5= 125.4

So, on the opening of the 6^th Candle in this series, the simple moving average would have value of 125.4.

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Key stages of ‘Golden Cross’ as mentioned in INVESTOPEDIA

There are three key stages to a Golden Cross. The first stage requires that a downtrend eventually bottoms out as selling is exhausted. In the second stage, the shorter moving average forms a crossover up through the larger moving average to trigger a breakout and confirmation of trend reversal. The last stage is the continuing uptrend for the follow through to higher prices. The moving averages act as support levels on pullbacks, until they crossover back down at which point a ‘Death Cross’ may form. The Death Cross is the opposite of the Golden Cross, as the shorter moving average forms a crossover down through the longer moving average. 

The chart above is that of Nifty 50 Index and the daily chart of the Nifty 50 Index displays a classical Golden Cross example. In the above chart, the green moving average line is 50-Day Simple Moving Average (SMA) and the red line is 200-Day SMA.

Once the 50-Day SMA crosses the 200-Day SMA to the upside, we have a Golden Cross. We have highlighted this with a green arrow. Thereafter, the direction of the trend enters into a strong uptrend. The Golden Cross signal was generated in the month of May 2016 and thereafter, the Nifty 50 index entered into an uptrend. The signal was generated around the level of 8160.

The chart above is that of Maruti and the daily chart of Maruti displays a classical example of “Golden Cross”.  In the above chart, the green moving average line is 50-Day SMA and the red line is 200-Day SMA.

Once the 50-Day SMA crosses the 200-Day SMA to the upside, we have a Golden Cross. We have highlighted this with a green arrow. Thereafter, the direction of the trend enters into a strong uptrend. The signal was generated in the month of July 2016 and thereafter, the stock of Maruti entered into an uptrend. The signal was generated around the level of 4456.

The Golden Cross is formed by two moving averages. When the faster moving average crosses over a slower moving average, we get a Golden Cross signal.

The most common moving average for trading the Golden Cross pattern is the 50-Day SMA which is a faster moving average and 200-Day SMA which as a slower moving average.

There are two types of Golden Cross signals, based on their appearance:
1. Bullish Golden Cross – This occurs when the faster i.e. 50-Day SMA breaks the slower moving average i.e. 200-Day SMA upwards.
2. Bearish Golden Cross (Death Cross) – This occurs when the faster i.e. 50-Day SMA breaks the slower moving average i.e. 200-Day SMA downwards.

Crossovers add strength to many types of trading strategies, but a traders needs to understand that the crossover can generate optimum results in a trending market. Moving average has a tendency to emanate false signals amid the sideways stage or where there is no significant movement in price. For a considerable time, masters in technical analysis have attempted to filter or alter the crossover systems with a specific end goal to diminish whipsaws.  However, there is no study to demonstrate that this system can provided optimum results in all phases of the markets. However, there have been a few important observations that all moving averages eventually converge toward a single price level in dead markets. The bigger the difference between the two moving averages, the more powerful the Golden Cross. So stop using crossover signals when there is no difference or less difference in the two moving averages, and move to other indicators to predict the next move of the stock.

Golden Cross and Death Cross are typical trend-following strategies that are fail-safe and very simple but are rarely followed diligently by traders and investors. Golden Cross is a buy signal when a shorter term Moving Average crosses over a longer term Moving Average from below; vice versa for Death Cross when the short-term MA crosses the long term MA from above, generating a sell signal. Generally for short term, 20 or 50 days and for long term 100 or 200 days MAs, are used. The biggest reason this strategy is not followed because of the simplicity. People cannot digest simplicity and therefore abandon it. However, when this strategy is back-tested on individual stocks and indices, it works equally well on both. Many times there are whipsaw losses and that could be another reason why people stop using the crossover strategy mid-way. But had they continued even during sideway phase of the market, they will be able to capture the large trends which are often missed by the majority. Thus, ability to follow the crossover strategy consistently in good and bad times will surely give far superior returns in the long term. The best part of the crossover system is that, during bearish phase, it keeps investors out of the market, but only when the market bottoms out does it give a buy signal.