To understand what a death cross signal is and how to use it to your advantage, there are some terms and concepts which you must understand first. The death cross signal on a stock chart describes the 200-day moving average price of a stock or security crossing the 50-day moving average (DMA = Daily Moving Average) on a downwards angle while following a downward trend. This is considered to be a sign of a bearish (pessimistic) market, and some investors feel this is a good time to sell.
So what does all that really mean, in plain English? We’ll start with moving averages. These averages can be used to determine if investing in a particular company is a good idea. An average can be found by adding up all the figures in a series, or group, and then dividing by the number of figures. For example, if a stock price over five days is thus: 2.70, 2.65, 2.69, 2.72, 2.71, then the total of the figures is 13.47. This number, when divided by 5 (number of figures), yields an average price of 2.694, or just 2.69.
Moving averages consist of a series of daily averages charted on a line graph. Because these charted figures are averages, the line graph is much more stable than a daily pricing graph. The moving average simply means that every day, a new average is calculated and charted. So, to continue the earlier example, if on the second day of the period, the daily price for the sixth day is 2.72, all the figures from the second day through the sixth are added up, with a result of 13.49. Dividing this number by five (five figures: first day omitted, 2.65 [second day], 2.69, 2.72, 2.71, 2.72 [sixth day]) yields the average price of 2.70 (rounded from 2.698). All the averages for a specified time period (usually 50 and 200 days) are plotted on a graph with the first one at the far left.
Death Cross vs. Golden Cross
The chart is analyzed for trends and other trading signals. Both the 50-day and the 200-day moving averages are placed on the same chart and compared. If, after an upward trend, the 50-day moving average crosses the 200-day moving average, it is referred to as a golden cross, and considered a good time to buy. On the other hand, if the 50-day moving average crosses the 200-day moving average on a downward trend, following a downward slope, this is referred to as the death cross and is, by some investors, considered a good time to sell.
When the death cross occurs, the 200-day moving average becomes what is known as the resistance. The resistance is the upward boundary of a security’s price. The security will rarely rise above this level. In the case of a golden cross, the 200-days moving average becomes the support. The support is the opposite of the resistance – the price will rarely fall below this level. This is why crossovers (crosses) are so significant. Although they can help many trading strategies, they have more significance in markets with varying security prices.
Effective Usage of the Moving Average
One problem with moving averages is that they often show trends at a time too late to make a difference to the investors. However, more information can be gained about the security when using a long time period, as small effects on the price are exaggerated in a longer time span.
Where Not to Use Moving Average Analysis
Some markets are referred to as “persistent range-bound markets.” In this type of market, there is very little variation in security pricing, making analysis of moving averages and other information not as useful as in a market with more varying prices for specific securities. In this type of market, the averages move toward a single price level, so market direction is difficult to determine. Other forms of technical analysis are more useful than moving averages for these markets.
Where To Use Moving Average Analysis
One trend that moving averages help signify are price patterns. A reversal pattern occurs when a security’s price has been rising, but suddenly turns downward. The reversal pattern can also describe when a security’s price has been falling, and suddenly turns upward. A second type is the continuation pattern. This pattern refers to when a security’s price has been on a temporary change, but will return to its previous trend at some point in the future.
Although the death cross pattern has”historically resulted in a 0.4% drop in the S&P the month after,” (Chris Ciovacco, July 5, 2010, “The ‘Death Cross’ is Not So Deadly…” http://www.dailymarkets.com/stock/2010/07/05/the-death-cross-is-not-so-deadly-us-stocks-may-surprise-by-end-of-the-year/) it doesn’t mean that the market will always fall. As with any analysis, you must consider other factors about the market to decide whether to buy or sell your stocks and securities.