Traders rely on many different technical indicators to inform their decisions. Moving averages are one of the most common technical indicators since they help smooth out market noise and make it easier to see important trends. They also provide a way to generate quantitative trading signals.
In this article, we will take a look at the Golden Cross chart pattern, best practices for using it, and a real life example of the chart pattern.
What Is the Golden Cross?
The Golden Cross is a bullish chart pattern, based on the moving average crossover strategy, whereby a short-term moving average crosses above a long-term moving average.
Learn more about moving average trading strategies here.
There are three stages to the chart pattern:
- There is a previous downtrend that is starting to lose momentum, setting the stage for a reversal.
- The trend reversal occurs when the short-term moving average crosses above the long-term moving average.
- There is an uptrend following the trend reversal and the moving averages become key support levels.
The greater the distance between the two moving averages, the more powerful the trading signal. If the price is in a strong downtrend and quickly reverses higher, the short-term moving average has a greater velocity and the trading signal is more reliable than less extreme situations.
The opposite of the Golden Cross is the Death Cross, whereby the short-term moving average crosses below the long-term moving average and signals a new prolonged downtrend.
How to Trade the Golden Cross
The Golden Cross is a very versatile chart pattern, but there are some parameters that can ensure accuracy.
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Find the Right Security
The Golden Cross uses moving averages, which are lagging technical indicators. It works best when identifying changes in strongly trending, rather than range-bound, markets. In other words, you shouldn’t use a Golden Cross if there are frequent crossovers since there’s a low signal-to-noise ratio.
Here’s an example of a situation where the market is too choppy:
In this example, there is no well-defined downtrend prior to the Golden Cross chart pattern. The sideways price action is too choppy to generate reliable trading signals and the Golden Cross strategy shouldn’t be applied in this situation. We will take a look at a more ideal situation later.
Select the Type & Duration
The simple moving average, or SMA, is the most common type of moving average used in the Golden Cross, but there are several other options to consider depending on the situation.
The most popular types of moving averages include:
- Simple Moving Average: The SMA calculates the simple average price over a given timeframe.
- Exponential Moving Average: The EMA is similar to the SMA but places an emphasis on more recent prices.
- Volume Weighted Moving Average: The VWMA is similar to the SMA but places an emphasis on prices with higher volume.
The 200-period and 50-period moving averages are the most common periods used to calculate a Golden Cross, but you can adjust the time frame of the moving average depending on your needs. For example, a day trader may prefer a 5-minute and 15-minute moving average to identify intraday trading opportunities.
Manage the Trade
The Golden Cross generates a buy signal when the short-term moving average crosses above the long-term moving average. At that point, you would typically purchase the underlying security and use the moving averages as new levels of support for the subsequent trend higher.
Often times, traders use the long-term moving average as an initial stop-loss for the position and the short-term moving average as a kind of trailing stop-loss or take-profit point. You can also use other forms of technical analysis to set these stop-loss and take-profit points, however.
Examples of the Golden Cross
Let’s take a look at an example of a Golden Cross in the wild.
The following chart shows a Golden Cross in Fortis Inc. (NYSE: FTS) using the 50-day and 200-day moving averages:
In the example, you can see that there was a prior downtrend between mid-September and mid-October before the Golden Cross occurred in late-October. The reversal was followed by a significant uptrend throughout mid-November – even after the short-term increase immediately following the signal.
The trader may have purchased the stock immediately following the Golden Cross and set the stop-loss at the 200-day moving average. Once the stock broke out higher, the trader could have switched to the 50-day moving average as a moving take-profit target and as a way to eventually lock in profits.
The Bottom Line
The Golden Cross is one of the most popular chart patterns for both long-term investors and short-term traders given its ease of use and versatility. In fact, moving average crossover strategies are one of the most common quantitative trading strategies – they’re a battle-tested option.
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