Price movement is still one of the key factors in spotting a trend
A golden cross is a technical indicator that is always a predictor of a bullish trend for stocks and other securities. A golden cross forms when a short term moving average crosses over a longer term moving average. In many cases, a simple 50-day and 200-day moving average are used. This is because a longer time frame is usually predictive of a stronger rally.
In this article, we’ll define the phases of a golden cross, explain what moving averages and other indicators traders use to identify and confirm a golden. The article also addresses other topics such as how a golden cross is different from a death cross. And it will touch on some limitations to using the golden cross as a trading tool.
How to Identify a Golden Cross Signal
There are three distinct phases that investors look for when identifying a golden cross.
- The first phase is when a security bottoms out. This indicates that selling volume is low.
- Next, the price begins to trend upwards until the short term (or fast) moving average crosses over the long term (or slow) moving average. This is when the cross occurs.
- The last step is a continued uptrend that signals a profitable golden cross trade.
What Simple Moving Averages do Traders Use to Identify a Golden Cross?
In general, investors look at 50-day and 200-day moving averages as the fast and slow moving averages. This is because longer moving averages tend to indicate longer, more sustained breakouts.
However, day traders will frequently use 15 minute or 30 minute moving averages for fast intraday trading. The real decision for investors when interpreting buy and sell signals is how quickly they want to enter and exit the trade.
A simple moving average is calculated by adding up the closing prices for each of the time periods represented and divide it by the overall time frame. So a simple five-day moving average is calculating by adding up the closing prices for the previous five trading days and dividing by five.
The moving average is (20 + 20.25 + 20.17 + 20.32 + 20.23)/5 = 100.97/5 = 20.19 SMA
At the close of the next trading day, the most recent closing price replaces the oldest price and which resets the moving average. Day traders will look for much shorter time frames such as the 5-period and 15-period moving averages as they are only concerned with profiting from intra-day price movement.
The time period of the chart can also be adjusted. Day traders may want to look at candlestick charts that are adjusted every minute or every hour. Long-term traders may be more interested in charts that show price movement in weeks or months. Like the moving average, the length of time makes a difference in how investors interpret a breakout. The longer the time frame, the stronger a golden cross breakout will tend to be.
What Other Moving Averages do Traders Use to Identify a Golden Cross?
In addition to using a simple moving average, some investors use other moving averages such as an exponential moving average (EMA) or volume-weighted moving average (VWMA) as the reference point for a golden cross.
- Using an exponential moving average (EMA) – An exponential moving average is similar to a standard moving average with a multiplier being used that assigns more weight to recent closing prices. For some investors, this makes the EMA a more accurate indicator of price movement.
- Using a volume-weighted moving average (VWMA) – The volume weighted moving average is similar to the exponential moving average except it puts more emphasis on the trading periods with the highest volumes. This is significant because most sustained price moves are supported by high trading volumes and can create a golden cross signal earlier than using an SMA or EMA. The VWMA is one of the best tools for detecting both when a trend is coming and when it is ending. When viewed on a daily chart, a VWMA line may appear to have more waves in it – this reflects periods of higher trading volume.
- Using a VWMA with an SMA – In this strategy, traders can use a VWMA as their short-term moving average with an SMA as their long-term moving average. The rationale behind using the VWMA for the short-term moving average is because the short-term moving average is considered the fast moving average and is always the trigger for a golden cross. As such, the VWMA is more sensitive to a higher trading volume.
What Other Technical Indicators Help Confirm a Golden Cross?
Because the golden cross is a single event, it requires sustained upward price movement to become a profitable investment. Therefore investors should use momentum indicators such as relative strength index (RSI) to help determine whether the stock they are looking at is overbought or oversold.
The RSI is an oscillator that assigns a value between 0 and 100. A security with a value above 70 is delivering an overbought (or overvalued) signal. Conversely, a security with a value below is delivering an oversold (or undervalued) indicator. Like the golden cross itself, the RSI is a lagging indicator so it is possible for prices to continue to rise even as the RSI registers an overbought condition. Similarly, the RSI may be signaling an oversold condition but the prices continue to move down. With this in mind, traders should use the oscillator in the context of the prevailing trend.
Similar to the relative strength index, another technical indicator that can be used to confirm a golden cross is the moving average convergence divergence (MACD). The MACD shows the relationship between two exponential moving averages (the 26-day and the 12-day) which is called the MACD line. A separate nine-day EMA of the MACD is called a signal line and is shown on a daily chart as sitting on top of the MACD line. The idea is that when a security crosses above the signal line, it is a buy signal. When it crosses below the signal line it is a sell signal.
Why is a Golden Cross Associated with a Candlestick Chart?
Candlestick charts are considered by some technical analysts to be a more reliable indicator of price movement. A candlestick chart clusters data for multiple time periods into single “candles”. The significance of a particular candle comes from its size, color and shading. All of these give traders more detailed information about overall price movement, thus making a golden cross more significant.
How is a Golden Cross Different From a Death Cross?
The golden cross and death cross are often times linked together. In fact, the death cross is sometimes referred to as a variation on the golden cross. Both the golden cross and death cross confirm the reversal of a trend marked by a short-term moving average crossing over a long-term moving average.
The difference between the two indicators is the direction. A golden cross is always a bullish indicator because it is showing a short-term moving average that is trending upwards. A death cross by contrast occurs when a short-term moving average crosses below a long-term moving average. This is a bearish signal. Experienced investors may use a death cross as a trading signal to take a short position on a stock. It is possible for frequently traded stocks to display a number of golden cross and death cross indicators over a period of time.
What are the Limitations of the Golden Cross?
Like most technical indicators, the golden cross is a lagging indicator. This means it is only in evidence after the price movement has already happened. As we pointed out above, the third stage of a profitable golden cross pattern is sustained price movement to the upside. In many cases, a golden cross may be short-lived. If a trader takes a long position, they could be left with a losing trade. Therefore, it’s important to use different signals and indicators such as stochastic oscillators to make a more educated guess as to a trade’s direction. And, like all trades, investors need to let their own risk parameters guide their trading.
Some Closing Thoughts on the Golden Cross
The golden cross is one of the strongest indicators of strong market sentiment in favor of a security. Most commonly defined as occurring when a short-term simple moving average (SMA) crosses above a longer-term SMA, other moving averages or a combination of moving averages can be used.
A golden cross is always a bullish signal. Conversely, a death cross is always a bearish signal. The difference between the two crosses is the direction that the security is moving. Like many technical indicators, the golden cross is a lagging indicator which means that it is only reflecting an event that has already occurred. For investors looking to predict the strength of a golden cross, they should look at other momentum indicators such as the Relative Strength Index (RSI) or Moving Average Convergence Divergence (MACD) lines to get a better sense of overbought or oversold sentiment among investors.