Moving Averages, the Golden Cross and the Death Cross

MoWhat are moving averages, and how do they work? Indicators that allow one to interpret a series of data and identify trends. Because they are based on past data, they are considered lagging or trend-following indicators. Traders use them primarily, to smooth out abnormal price movements.

There are different types of Moving Averages that can be used by traders depending on their type of strategy. Moving Averages are generally divided into two categories: Simple Moving Averages (SMA) and Exponential Moving Averages (EMA).

The Simple Moving Average (SMA)

To understand moving averages and how they work, we can start with the simplest one: the SMA, or Simple Moving Average. The SMA extrapolates data over a given time interval and returns the asset’s average price.

If the SMA is based on 10 days, it will take the last price of each day and calculate its arithmetic mean. With each passing day, it considers only the last 10 days, ignoring data from past days. That is why it is called mobile.

All prices in an SMA have equal weight, regardless of how recent they are. However, some traders believe that the more recent the data, the more relevant it is and that the SMA, not considering this factor, is particularly slow to detect market corrections.

This is because the algorithm handling it gives the same relevance to each input, no matter how far back in time. In this way, if long time intervals are chosen, the last value analysed, chronologically very ‘far away’, has the same valence as the first.

The Exponential Moving Average (EMA)

Traders in need of a more up-to-date indicator will want to know what the Exponential Moving Average is and how it works.

The EMA assigns more weight to the most recent price inputs. This makes it more sensitive to sudden price reversals and fluctuations.

As EMAs are better at predicting turns more quickly than SMAs, they are often favoured by traders with short-term strategies such as day trading and swing trading.

The problem with the EMA is that, by giving more importance to the last daily price, it may give misleading signals, e.g. in the case of a sudden change in the price trend. This case is called the Whipsaw effect, which affects markets considered more volatile to a greater extent.

Choosing and Using Moving Averages

When choosing which moving averages to use in your strategy, it is important to consider both the difference between EMA and SMA, and the time frame on which the individual MA indicator is based. In fact, a moving average that analyses the last 100 days will react more slowly to new information than an MA that only considers the last 10 days.

If your strategy is long term, however, this is not a problem, because it is less likely that a single piece of new information over 100 days will be relevant to your strategy.

Usually MAs are used in combination on the same chart, e.g. to detect bullish or bearish markets.

Many people use a short-term MA in combination with a long-term MA to identify these market phases. Whichever period you are considering, these lines often cross: this event is called a crossover.

There are two key crossovers in Technical Analysis: the Golden Cross and the Death Cross.

The Golden Cross is a bullish crossover and occurs when the short-term MA crosses the long-term MA upwards, suggesting the start of an upward trend.

Conversely, the Death Cross is a bearish crossover and occurs when a short-term MA crosses the long-term MA downwards, indicating the start of a downward trend.

When you hear of a golden cross in Bitcoin, it means that there has been a significant rise in its price!

Be careful, however, about the context, and especially the period that analysts consider, when making these statements.

Avoiding Whipsaws

It is important to remember that moving averages are indicators that follow the price with a certain delay and have no predictive value. This means that both crossovers will provide confirmation of trend reversal when it has already occurred. The delay is greater, the longer the period on which the MA is based (100 days, 200 days).

Let’s take a practical example. Let’s say you follow the buy-the-dip strategy, i.e., you intend to buy a certain asset when its price reaches a low point. This usually happens at the end of a bear market, just before the golden cross, where the short-term moving average exceeds the long-term moving average.

So, a golden cross does not correspond to the lowest price of the period, from which the bull market starts. When the cross occurs, the dip has already passed!

In other words, crossover is usually only a confirmation, a consolidation of a process that has already begun, to which many factors and indicators contribute.From this, we can see that it is not an event that should be taken.

Literally, it is not an inviolable law that tells us where prices will go in the future. On the contrary, if one is analysing a chart in a very volatile market’s short timeframe (period), there could be numerous potentially misleading crossovers if one needs to learn how to read them.

If we take the chart of the Nike stock during the 2020 crisis, we see that in a few months a death cross was succeeded by a golden cross. This is precisely the Whipsaw effect we saw above.

These examples can be used to extrapolate some guidelines to be followed to avoid errors and cognitive biases given by these high crossovers:

Now that you know what simple and exponential moving averages are and how they work, you can test what you have learned on our dedicated trader exchange, Young Platform Pro. On this platform, you have both indicators at your disposal, and you can set the time interval for which you prefer to use them.