As its name implies, the death cross is a bearish signal for an equity
Technical analysts look at price movement on price charts by way of indicators. One of the bearish indicators is known as the death cross. A death cross occurs when an asset’s short-term moving average crosses below its long-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 stronger selling pressure.
In this article, we’ll define the death cross and why it is a significant trading signal. We’ll also review the golden cross which is the opposite of the death cross and answer the question of whether the death cross has any limitations.
How to Identify a Death Cross Signal
The death cross is a technical chart pattern that indicates an asset has the potential to be exposed to major selling pressure. A death cross is a visual signal that appears on a stock chart when an asset’s short-term moving average goes below (or crosses) its long-term moving average.
Although traders can use virtually any time frame to set the parameters for a death cross, the most common short-term moving average is the 50-day simple moving average (SMA) and the most common long-term moving average is the 200-day simple moving average (SMA). However some traders feel that crossovers that happen over shorter time periods (such as 30-day and 100-day moving averages) provide better confirmation that a trend is strong an ongoing.
The universal condition that must be present for a death cross is having a shorter term moving average crossing below the longer term moving average. A death cross pattern is usually preceded by an increase in trading volume.
A death cross tends to be more significant when there is a large gap between the moving averages. Without a large gap, a death cross may simply indicate that investors are taking profits which means the stock will likely begin to recover fairly quickly.
However, when a golden cross appears after a stock has already lost 20 percent of its value, it is a stronger indicator of a bearish pattern. At this point, investors who have not already exited their position will start to sell. This will usually cause further downward pressure on the stock price as investor psychology kicks in and investors begin to sell.
What is the Significance of the Death Cross?
The death cross is a significant technical indicator for traders who are interested in short selling an equity. Short selling refers to the sale of security such as a stock, in anticipation of prices falling. The trading strategy is motivated by the belief that the prices of a security will drop, providing an opportunity for the stocks to be repurchased later and for the difference in price to be taken as profit.
Short sellers borrow shares of stocks they don’t own and try to sell them at the current price with the aim of rebuying them once the price drops significantly. The aim of this strategy is to benefit from the difference between the price of short selling and the cost of rebuying the stocks.
And on a macroeconomic level, the death cross has been a reliable predictor of not only recessions, but of the most severe bear markets of the last 100 years, most notably the stock market crash of 1929 that ushered in the Great Depression to 2008 and the Great Recession.
If investors identified the death cross, and got out of the market before these bear markets hit, they would have avoided losses which, in some cases, were as high as 90 percent at the peak of the Great Depression.
Although they have been right on many significant occasions, a death cross has not always been a stand-alone predictor of a bear market. In 2016, a death cross formed but the market did not go into a bear market. Instead 2017 proved to be a year of strong stock performance.
Although it is considered a long-term indicator, in contrast to a short-term indicator like the doji, a death cross is more significant in signaling that the short-term momentum in a stock or stock index is slowing down. One of the reasons a death cross can be accurate is that it can be a self-fulfilling prophecy among investors. As more investors start to sell, volume increases, which can cause further selling.
Is There an Opposite Signal to the Death Cross?
The golden cross would be the converse of the death cross. The golden cross is a bullish signal that occurs when an asset’s short-term moving average crosses above its long-term moving average.
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 Death Cross?
The primary limitation of a death cross is that while it can accurately predict a change in short-term momentum, it is not always an accurate predictor that a long-term bear market is approaching. An example of this occurred with Facebook – now Meta Platforms (NASDAQ: FB) in 2018.
FB stock showed two golden crosses. The first one, which occurred in April, was a false cross that preceded a significant upturn for the stock. The second one in September was an accurate predictor of what would turn out to be a prolonged bearish period for the stock – and in fact the tech sector in general.
Historically, a death cross seems to hold up best once an asset has already lost 20% of its value. In those cases, investors who got out of a position have tended to minimize losses. Smaller corrections may indicate losses that have already been factored in, which could mean the stock is a buying opportunity.
Some Closing Thoughts on the Death Cross
A death cross is one of many signals that a trader can identify to determine whether or not to exit a position. Although a death cross can be identified at any time period, the existence of one that occurs when a stock’s 50-day simple moving average crosses over its 200-day simple moving average has tended to be the most accurate for predicting bearish trends. Like any indicator, a death cross can give off a false positive and for that reason should be combined with other indicators to determine whether or not to sell an asset.
