Moving Averages, the Golden Cross and the Death Cross
July 30, 2021
Moving averages are indicators that allow you to interpret a series of data and identify trends. Because they are based on past data, they are considered lagging or trend following indicators.
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)
The SMA takes data from a given period and produces the average price of the asset.
If the SMA is based on 10 days, it will take the closing price of each day and calculate the arithmetic average. With each passing day, it always considers only the last e.g. 10 days, ignoring data from past days. This is why it is called “moving”.
All prices in an SMA have equal weight, regardless of how old they are. Some traders, however, believe that the more recent the data, the more relevant it is, and that the SMA, by not considering this factor, is particularly slow to detect market corrections.
The Exponential Moving Average (EMA)
For traders who require a more up-to-the-minute indicator, there is the Exponential Moving Average.
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 for example in cases of a very short change in price trend. This case is called the Whipsaw effect.
The term whipsaw is derived from the zigzag movement of lumberjacks when cutting trees with a saw called a “whipsaw”. A trader is considered “whipsawed” when the price of an asset in which they have just invested moves abruptly in the opposite and unexpected direction to the trend.
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.
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 buy when prices are at their lowest. This usually happens at the end of a bear market, just before the golden cross where the short-term MA exceeds the long-term one.
So a golden cross does not correspond to the lowest price of the period, from which the bull market then starts. That price, that dip, has already passed!
The crossover is usually just a confirmation, a consolidation of a process that has already started, to which many factors and indicators contribute.
A crossover, however, should not be taken as a literal and inequivocable sign of bull or bear trends. It should be considered that, especially if you are analysing a short period and a very volatile market, there could be many potentially misleading crossovers if you do not know 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.
In this context, if an inexperienced investor took the death cross as a sign of the start of a new bear market, they may have sold all their shares and got whipsawed. Looking back at the price, perhaps the death cross was the very point where they would have had their last chance to buy at a good price.
These cases teach us some useful practices to avoid errors and cognitive biases given by these crossovers:
- Combine several Technical Analysis indicators to confirm signals
- Before starting, prepare a trading strategy, but above all an exit strategy, a plan B.
- Check the latest news on the project you are investing in to make well-founded predictions
- Check that the trading volume is consistent with the crossover