Last Updated on 17 November, 2020 by Samuelsson
What is A Death Cross?
A death cross is when a short-term moving average crosses under a long-term falling moving average, signalling a reversion of the trend. Investors and traders use the death cross to understand when the market is likely to go from bullish to bearish. The technical interpretation of a death cross is that the short term trend and the long term trend have shifted. Therefore, traders and investors expect the new trend to begin a bearish market phase. The most common moving average settings are the 50- period and 200-period moving averages. Therefore, for many market participants, a crossover between the two is a common sell-off signal.
In the image above, the purple line is the 200-day MA, and the orange/yellow is the 50-day MA.
The death cross has historically proven to be a good indication of an approaching bear market. Those who would have exited the market before some of the greatest bear markets and financial crashes of the 20th century, had avoided volatility and saved a lot of money.
The death cross has succeeded quite well in predicting these events. The most successful example to date was the financial crash of 1929. During the three year long bear market of the 1930s, where the S&P fell 83,4%, investors could have avoided the lions share of the losses, simply by staying out of the market as soon as the death cross was effectuated. Here you can view the daily chart of the 1929 -1932 bear market.
False and True Death Crosses
Some investors and traders will, erroneously, assume that any crossover is a death cross. For there to be a death cross, both the long term and short term moving averages must be falling. Since the death cross is a reversal signal, the price is also required to come from a bullish long term trend. This is defined as that the long term moving average is rising.
Using the Death Cross In Daytrading
Day traders may use the death cross in their daytrading. However, it’s important to note that low timeframes, like 20 or 5-minute bars, will produce much less accurate signals than daily bars. Knowing this, traders should try to employ other indicators and filters to filter false death cross signals.
The Three Stages of a Death Cross
To make the concept clearer, the death cross can be divided into three stages:
Stage 1: The death cross could be said to be a breakout signal. At the same time, it’s also a reversal signal. Since there must be a trend to revert for a reversal signal to take place, the first stage of the death cross is that the long term trend is rising.
Stage 2: The second stage is when the shorter-term average crosses under the now falling longer term moving average. What this represents, is that both the long term and short term trends are falling, while the short term trend strength is accelerating.
Stage 3: Once the crossover of the moving averages has taken place, some traders and investors will wait for some time to see whether a new trend persists. By waiting, you mitigate the risk of acting on a false death cross signal. However, it also means that you, once the death cross is verified, have missed a lot of the trend movement.
Most traders will not care for the confirmation. Once the death cross has taken place, meaning that the shorter term moving average crosses under the longer term moving average, they consider the death cross to be finalized. The benefit of not waiting for the death cross confirmation is that you will be able to enter or exit earlier. Thus you will minimize losses, or maximize profits if shorting the market. The disadvantage of not waiting for confirmation is that the number of false death cross signals will be higher.
Support And Resistance Before And After A Death Cross
Before a death cross, the long term moving average often acts as a resistance level. This means that the market will struggle to penetrate the moving average. However, once the death cross has taken place, the moving average instead becomes a resistance level. In other words, the market will find it difficult to get above the moving average.
Often, the new resistance level will be challenged. If it holds, it’s a sign that the new trend might be here to stay. However, the market may still penetrate the moving average from underneath. As long as there is not a new moving average crossover, the odds are still in the favour of the death cross signal.
Death Cross VS Golden Cross
The golden cross is the direct opposite of the death cross. While the death cross is an indication of an imminent bear market, the golden cross instead indicates a bull market. For a golden cross to take place, the long term moving average must be rising and penetrated from underneath by the short term moving average. As with the death cross, the most common setting for the moving averages are 50 and 200.
In some investment strategies, the death cross and golden cross go hand in hand. Typically, the golden cross acts as the entry signal, while the death cross acts as the exit signal. Using this as a market timing signal would have saved you from a lot of unwanted volatility during recent market crashes.
Death Cross Cons
One of the major cons of the death cross is that it’s a lagging indicator. Since moving averages are calculated on price data stretching far back, we run the risk of acting on death cross signals that are not indicative of future trends, but only show past market trends. This issue of it being a lagging indicator is even more pronounced for those who wait for a confirmation of the death cross.
Another con of the death crosse is that it sometimes produces false signals. However, this is not unique to death crosses, but is true for any investment or trading strategy. The best way of mitigating false signals is to add additional filters such as the ADX, MACD or RSI.