Golden Crosses, Dead Crosses

07/25/02 01:55:49 PM

by David Penn

The Japanese add a flourish to the old-fashioned moving average crossover.

Security: QQQ
Position: N/A

So much of what makes the Japanese approach to chart analysis unique to Westerners is the way that Japanese chartists have sought to make symbols for price action as interpretive as possible. This is most obviously so in the popularity of Japanese candlesticks, which have displaced traditional, Western bars on the stock, futures and currencies charts of many traders in the West. Knowing at a glance whether a day, week or three-minute slice of the trading day represents a victory for the buyers, the sellers, or has ended in a tie, is a simple, yet enormous breakthrough for traders looking to assimilate as much information as quickly as possible.

The "flourish" the Japanese have brought to the simple moving average crossover is another example of building simple trading strategies on the backs of easily interpreted price action. The moving average crossover has been recognized by many chartists as one of the most basic, yet effective, trading systems ever devised. A moving average crossover strategy features two moving averages -- most frequently simple moving averages, though exponential averages and other varieties have been used by many. One moving average is shorter than the other, with 5- by 20-period, 9- by 18-period, and 50- by 200-period being among the many popular combinations. A long position is entered when the shorter moving average crosses up over the longer moving average. That position is exited when the shorter moving average moves back beneath the longer moving average. Short positions can be taken by reversing the signals (going short when the shorter moving average crosses under the longer moving average).

One of the more obvious flaws in such a strategy is that it will underperform in trendless markets. When prices are trading in a range, a trader using a simple moving average crossover strategy will likely suffer fleeting profits as positions are repeatedly stopped out. While there is nothing a trader following a simple moving average strategy can do when a market turns trendless (other than to stop trading that market, which is perhaps the most prudent action to take), the Japanese concept of "dead crosses" and "golden crosses" can help a trader decide when a bullish or bearish moving average crossover is worth pursuing and when a crossover is best ignored.

Simply put, a dead cross occurs when the shorter moving average and the longer moving average are not in gear, or moving in the same direction. If the 9-day moving average crosses the 18-day moving average going downward, yet the 18-day moving average is flat, then that would be considered a dead cross and not worth trading--especially with regard to initiating a new position. There may be instances when a dead cross is a worthwhile tell to exit a position that is about to reverse. But insofar as there is a disconnect between the short-term outlook and the longer-term outlook, a new position is probably ill-advised.

A "golden cross" in January leads to a winning short trade in the QQQ. A profit-taking opportunity arises with the "dead cross" at the end of February. Another "dead cross" appears in late March.

Graphic provided by: MetaStock.

A golden cross on the other hand, refers to a moving average crossover in which both the short-term and the long-term moving averages are moving in the same direction, up or down. Here, both the short-term and the long-term outlooks are in gear and the trend is more likely to sustain itself long enough for the trader to profit. When both moving averages are moving in the same direction, there is a better chance of advancing prices to continue climbing and of declining prices to continue falling. Depending on the trader's risk tolerance, a variety of exit strategies can be deployed in concert with the golden cross entry approach to simple moving average crossovers: from trailing stops to time stops. However, given the fact that simple moving average crossovers are a trend-following strategy, it is also possible to let a dead cross signal an exit from a position, with another golden cross being the signal to enter again, whether as a reversal or as a continuation of current gains.

There are other aspects to the golden crosses/dead crosses strategy. Many traders using this approach look for a divergence of 25% or more between the moving averages as a sign that prices may have reached an extreme and are likely to retrace or correct some. While there is an obvious challenges to this strategy (a 25% divergence could grow to a 40% or 60% divergence, with the trader exiting the position too soon), there is something to be said for exercising caution when the moving averages become greatly divergent. Another point about moving average crossovers is that often the lines converge without crossing before resuming their trends. Often these can be excellent ways of jumping on a trend that has consolidated somewhat and may be about to breakout and resume its trend -- without necessarily waiting for the moving averages to actually cross.

As an aside, 7- and 21-period moving averages are reportedly popular among many Japanese traders using the golden cross/dead cross simple moving average crossover strategy. This largely underscores the notion that the specific pair of moving average is less important than disciplined entry and exit rules, and sound money management with regard to overall risk exposure.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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Comments

Date:�07/25/02Rank:�5Comment:�

Date:�07/30/02Rank:�5Comment:�

Date:�07/31/02Rank:�5Comment:�Another point about moving average crossovers is that often the lines converge without crossing before resuming their trends. Often these can be excellent ways of jumping on a trend that has consolidated somewhat and may be about to breakout and resume its trend -- without necessarily waiting for the moving averages to actually cross That s a really interesting point. I ve noticed that but never knew what to do with it. Thanks Sue

Date:�12/28/03Rank:�5Comment:�

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Golden Crosses, Dead Crosses

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