Technical analysis is full of fun little terms like “bear trap,” “gravestone doji,” “falling knife,” “widow maker,” and “doomsday call.” Each term represents a specific scenario or pattern analysts use in everyday trading — and they’re usually not as bad as they sound. However, one chart pattern stands “head and shoulders” above those ominous expressions in terms of both significance and prevalence. New and experienced investors alike have come to know and dread this term. But is the fear well-deserved? To find out, let’s talk about the death cross.
But first, some context.
Simple moving averages explained
The simple moving average is a popular technical indicator that creates an easily-identifiable line across the chart using the average price movement within a given trading period. Moving averages, or MA, are a great way to remove all the noise from daily price fluctuations to create a smoother view of price action.
For example, if you wanted to get a 20-day moving average for a stock, you’ll need to take the closing prices of the last twenty trading days, add them up, and divide by twenty.
That will yield one data point. To create a line, you’ll need to redo the calculations for all trading dates. Or, to save you time, you can use any stock charting website to automatically generate moving averages.
The green line on the chart above indicates the 20-MA line, which traders and investors can use to help identify trend direction or things like support and resistance levels. They can also be used for stock patterns, which is what we’ll be talking about next.
Death cross definition
The death cross is a market chart pattern that appears when a stock’s short-term moving average (usually the 50-day moving average) drops below a long-term moving average (usually the 200-day moving average). This creates a cross with the two moving averages, hence the name. This signifies price weakness in the market and the possibility of a significant price drop and a long-term bearish market.
Here’s the usual breakdown of the price movement leading up to and after a death cross:
- The security moves in an upward or sideways pattern.
- The 50-day short-term moving average drops below the 200-MA line
- The price experiences a sharp or gradual decline.
Golden cross — the death cross for optimists
The golden cross is the opposite of the death cross. It’s a chart pattern that forms when a short-term moving average crosses above a long-term MA, possibly signaling market interest in the stock and potential bullish market sentiment. We’ll talk about that in a separate article.
Can the death cross pattern accurately predict market movement?
Many analysts believe that the death cross can predict major market downturns. They have cited examples of the numerous occasions when the death cross appeared before major economic disasters like:
- The Great Depression (1929-1939), which was caused by an unfortunate combination of circumstances like over-optimistic market speculations, high unemployment rates, oversupply and overproduction, mistakes by the Federal Reserve, and, of course, the stock market crash of 1929.
- The stock market crash of 1973, which was one of the worst stock bear markets in the 20th century.
- The dot com bubble in 2000, when over-enthusiastic investors and venture capitalists flocked to the new and exciting internet companies that were taking advantage of the new technology by presenting new ideas without regard to sustainability.
- The 2007 financial crisis, caused by a massive housing bubble, which in turn was caused by low interest rates and financial institutions getting a little too trigger-happy with their lending and mortgage operations.
However, death crosses have been noted to appear during small market corrections, which led to narrow or negligible price range movements. Here’s a quick example:
In the chart above, a death cross formed when the green line (50-MA) crossed below the orange line (200-MA). Common belief would tell us that the prices are about to experience a precipitous drop. Now, the stock did drop a little below the previous low, near $155, but that’s hardly a sinking ship to jump off of. We can also see that prices shot back up and even above previous trading levels. This means that, for this instance, it did not predict a significant price drop.
Furthermore, in the case of the 2007 Financial Crisis, the S&P 500 formed a death cross on December 2007, months after the actual start of the crisis.
So… is that a no?
Most experts agree that the death cross is a coincident indicator of market weakness rather than a sure signal for an upcoming bear market or recession.
Additionally, it is important to note that the death cross is a lagging indicator. Lagging indicators are observable patterns, changes, or measurements that happen after a shift in the underlying market or activity. This means that, before the death cross, the market has already been experiencing difficulty or downward price movement. Another logical way of thinking about this is that the moving averages that produce the death cross are based on previous closing prices and, therefore, may have no accurate way of predicting future price movements.
Death cross trading strategy
This doesn’t mean that death crosses are useless. Again, these chart patterns appear during short-term price deteriorations — which investors can see as a sign of continued market or stock weakness. While it cannot predict price movements with 100% certainty, it can act as a heads-up for investors and traders so that they can watch the security closely. This applies to trading cryptocurrencies, stocks, and commodities. Here are a few ways you can utilize the death cross pattern in your trading.
Profit protection
Many investors know what a death cross is and may use it as a trading signal. They’ll be on the lookout for one appearing in stock indexes, as it can be a useful bearish market timing signal. And with the widespread reputation of the death cross as the harbinger of bad times, many people might want to sell off their holdings to head off the perceived oncoming drop. Investors can follow this type of market behavior to protect their profits.
Entry for short positions
Traders who like to short stocks may look for death crosses in potential picks. They can use the pattern as the entry price and set stop losses above the 200-MA line. Using this pattern with other indicators is best to set more solid price levels and exits.
Potential future investments
Despite sounding counterintuitive to the point of being utter nonsense, death crosses have been noted to produce great short-term and longer-term gains. Keen-eyed investors can use the chart pattern to spot stocks displaying signs of price weakness, wait for the prices to bottom out, and then enter at discounted levels. Research also suggests that death crosses have preceded solid market gains in 3-, 6-, and 12-month timeframes.
Conclusion
The death cross is a technical indicator. And like all technical indicators, its appearance and interpretation are subject to a lot of factors, including overall market conditions and other technical indicators. Traders and investors can add it to their chart patterns to look out for, but it should by no means be used as a sole predictor of price movement.
