The Golden Cross: What is it and How to Identify it when Trading?
The ‘golden cross’ is a term often mentioned in trading circles due to its usefulness in spotting changes in trends while also being incredibly easy to use. This article will explain the concept of the golden cross, how to identify the golden cross and explore complementary indicators to use alongside the simple moving averages when analyzing changing trends.
What is a Golden Cross?
A golden cross occurs when the 50 simple moving average (SMA) crosses above the 200 SMA. The golden cross provides a bullish backdrop to the market as short-term price momentum advances higher, with the potential to evolve into a new long-term trend (uptrend).
The 50 SMA is an arithmetic average of closing price levels over the last 50 periods or days, if you are using the daily chart for example. Therefore, the 50 SMA is more reactive to more recent price movement than the 200 SMA, which averages out the last 200 closing prices and tends to create a smoother line, less reactive to recent prices than the 50 SMA.
Learn how to calculate simple moving average in our article, ‘Moving Average Explained for Traders’
How to Identify a Golden Cross
There are three main stages to the formation of the golden cross:
1. The lead up: Price action consolidates or, in some scenarios, turns sharply higher after trending lower for a considerable period of time. This provides the initial clue that the downtrend may be starting to lose momentum and could even result in an eventual trend reversal. The 50 SMA remains below the 200 SMA during this stage.
2. The golden cross: This is the exact moment the 50 SMA crosses above the 200 SMA, providing the bullish backdrop for the market known as the golden cross. The golden cross is often interpreted as a trigger to look for entries into the market.
3. Continued upward momentum: Price action advances higher after the golden cross is observed, often creating a fresh new trend (uptrend). Ideally, in this stage you may observe the shorter 50 SMA acting as dynamic support for price action and price continues to trade above the 50 SMA for some time.
The Simple Moving Average as a Lagging Indicator
By its very nature the simple moving average is a lagging indicator, meaning that it relies on past price action to provide assistance when analyzing current market conditions. Inherently, the SMA has a lag period, resulting in the signal being produced some time after the move has occurred.
Some may view this as a lost opportunity while others may appreciate the delayed signal as it may provide a greater level of conviction that the trend has indeed changed and we aren’t simply witnessing a short term retracement. Shorter-term traders like scalpers and day traders, seeking to capitalize on smaller moves, can make the indicator more responsive by simply reducing the short-term and longer-term moving averages when adjusting the input criteria.
The exponential moving average (EMA) places greater significance on recent price action, resulting in a more responsive MA. Learn the difference between SMA and EMA.
In addition to this, there are a number of technical indicators that can be utilized alongside the SMA when analyzing developing trend reversals, which are explored below.
Useful Indicators to Use with SMAs
For a trend to develop, a market first needs to break out of an existing range or consolidation phase. This can be analyzed purely from a price action point of view (observing price breaking above resistance or below support) or via the use of an indicator.
- Donchian Channel: The Donchian channel indicator identifies the high and low for a period of time and carries these levels forward on the chart to better visualize significant levels that contain price action. A break above or below these levels with sustained momentum could indicate the start of a long-term trend.
The chart below depicts a break above the Donchian channel with continued momentum (red circle), suggesting that a new trend may be emerging.
Since the golden cross seeks to identify a bullish trend reversal, it makes sense to use trend following indicators after the market has broken out of a period of consolidation.
- Moving Average Convergence Divergence (MACD): the MACD is a technical tool that averages price over a period of time. The smoothing effect this has on price charts help give a clearer indication on what direction the pair is moving.
Below it can be seen that the MACD actually provides the first indication of a new potential uptrend with the bullish MACD crossover (purple circle). This provides the initial basis of the bullish bias which is later reinforced by the golden cross which provides further support of the bullish bias.
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