A death cross is a type of technical trading pattern which is used to indicate a bearish move.
It is formed when you see a short-term moving average crossover below the long-term moving average on a chart.
While there is no universally accepted standard for moving averages used, generally speaking, a 50-day period is used for the short-term moving average while a 200-day period is used for the long-term moving average.
However, traders are free to use any periods they wish, provided that there is a relatively big difference between the short-term period and long-term period.
If using an uncommon set of periods, it is advisable to backtest these to determine their reliability as using the death cross with a 50-period and 200-period has been already proven across several historical contexts.
For example, the death cross has reliably predicted some of the most severe bear markets that have occurred – the GFC in 2008, the Great Depression of 1929, and the market crashes of 1938 and 1974.
It is however not infallible, as many traders learned in 2016 when a death cross formed.
Many traders exited the market expecting prolonged falls, only to see a relatively short and sharp 10% correction and a bull market heading into 2017.
As with many indicators, the death cross is a lagging indicator.
An important consideration in using a death cross is that in many cases, a fall of 15-20% has already occurred before a death cross is formed.
Therefore, it serves more as an indicator of a severe bear market forming, rather than as a reliable indicator of all price declines.
There are effectively two main ways traders can leverage a death cross in their trading.
The first is as a filter for spotting stocks which could become undervalued due to short-term fear-based trading.
By monitoring individual stocks that have experienced a death cross, investors with an eye on quality companies can spot opportunities to pick them up for cheap as the death cross can often create a self-fulfilling prophecy of further price declines as other traders react to it.
The second way to use the death cross is as a warning system by applying it to the general market.
That is to say, once the general market (e.g. the S&P 500) experiences a death cross, it might be a good time to unwind positions or put hedges in place to protect against major bear market corrections.
The death cross is a highly flexible indicator in that it can be applied across multiple time intervals.
Since the moving average period is universal, it means that a 50 period short-term moving average could be a 50 day, 50 hour or even 50-minute moving average, allowing traders to exploit both large and slow trends, down to small and rapid intra-day trends.
Conclusion
The death cross is a technical indicator signifying a bearish trend has formed.
While not always reliable for smaller moves of less than 20%, it has been found to predict some of the largest bear markets experienced in the last century.
The most common settings are to watch for a 50 period short-term moving average crossing under a 200-period long-term moving average.
The flexibility of the indicator is that traders can select their own periods and apply them to different time intervals such as days, weeks, minutes, and hours.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
