If you are a fan of the moving averages, then you will definitely enjoy reading this article. Today we will discuss one of the most important patterns related to moving averages – the golden cross (GS).
What is a Golden Cross in Trading?
A golden cross in trading occurs when a faster moving average crosses a slower moving average.
In order to make sure we are all grounded with what is a moving average, please read the below section.
Moving Average Explanation
The moving average consists of a line, which smoothes price action by taking the average closing price over “x” periods. This “x” period is defined by you the trader and really comes down to what suits your needs.
If the moving average is over 5-periods, it will take the closing prices of the previous 5 candles in order to give you an average value for the current period.
Let’s now take a look at a basic example for performing the calculation of a 5-period moving average:
$3.00
$3.20
$3.80
$4.00
$5.00
If you have these 5 closing prices of a security, then a simple moving average will give you the following average value with the opening of the 6th period:
(3.00 + 3.20 + 3.80 + 4.00 + 5.00) / 5 = 3.80
So, on the opening of the 6th candle in this series, the simple moving average would have a value of $3.80.
Got it?
Golden Cross Indicator
Now let’s get back to the golden cross indicator. As we previously stated, the GS occurs when a faster (shorter period) MA crosses a slower (longer period) MA.
The bigger the difference between the two SMAs, the more powerful the golden cross signal.
The classic setup for a golden cross signal is when a 50-period SMA crosses above a 200-period SMA.
Golden Cross
The above chart displays a classical golden cross trading example. The blue line on the chart is a 50-period SMA, while the red line is the 200-period SMA.
The chart begins with a strong downtrend, where the price action stays beneath both the 50-period and 200-period SMA.
Suddenly, the direction of the trend changes and the price begins increasing. Naturally, the 50-period SMA reacts faster to the price change. This is because the blue SMA takes into consideration less periods, making it more sensitive to price moves compared to the 200-period SMA.
Once the 50-period SMA crosses the 200-period SMA to the upside, we have a golden cross. We have highlighted this in the pink circle in the above chart.
Profit Potential of the Golden Cross Pattern
The golden cross pattern has a pretty straightforward price expectation and that is higher!
Since the signal takes into account so many periods (200), the expectation is that the move higher should be in direct correlation to the amount of time it took to generate the signal.
Therefore, we would not want to use a golden cross for a scalp trade for example.
Bullish Golden Cross Pattern Example
Again, we have a bullish golden cross pattern when the faster SMA on the chart breaks the slower SMA in a bullish direction.
Bulish Golden Cross
This is the same golden cross signal from the previous chart we discussed. However, this time we demonstrate the strength of the signal and the potential run a stock can make after a golden cross materializes.
In this particular example for First Energy Corporation, the stock went on a 9.2% run in 6 trading days.
Not a bad one-week return for all my swing traders out there.
3 Ways to Use the Golden Cross Indicator
Until now, we have only been using the SMA Golden Cross indicator to make our decision to enter a long trade.
However, the simple moving average is not the only indicator you can use to identify a golden cross.
Why the additional moving averages? In theory, depending on the stock you are trading, another trend indicator may provide more accurate and timely signals.
This of course will also come down to your preferences in terms of sensitivity of price and your risk tolerance levels.
Strategy #1 - EMA Golden Cross Trading
The exponential moving average (EMA) is another option for identifying a golden cross signal on the chart.
The difference between the SMA and the EMA is that the EMA places more emphasis on the most recent periods on the chart.
To get an EMA golden cross, I recommend you stick to the classic 50-period and 200-period rule, since these are common moving averages used by traders.
Bullish Cross and Death Cross
The above chart illustrates a few golden cross trading opportunities utilizing the 50 and 200-period EMAs.
The first golden cross is bearish (death cross) and the price starts a sharp decrease after creating the signal. The second one is a bullish golden cross, which sends the price in bullish direction. The third signal is another death cross, which indicates the start of another leg down.
Each of these three signals could be used to open a new trade and thus closing the previous one.
One point to note, you do not want to always be in the market, so you will need to apply some validation technique to guide you on when to take the trade.
I have yet to see a trading technique that wins by always keeping you in the market. You have to use some sort method for staying in cash until the “best” trading opportunity presents itself.
Strategy #2 - VWMA Golden Cross Trading
Now we will use the volume weighted moving average (VWMA) to trade the golden cross signals.
The VWMA takes into consideration a certain number of periods. However, the indicator places emphasize on the periods with higher trading volumes. This is why “volume” is in the name of the indicator.
We will now use a 50-period VWMA and a 200-period VWMA to attain golden cross signals. Let’s see how this works:
Bullish Golden Cross with the VWMA
The chart above shows a couple of golden cross indicators based on crossovers of the VWMA. When the blue 50-period VWMA breaks the red 200-period VWMA, we get a bullish signal on the chart.
After this signal, the security enters a long bullish trend. See that the two VWMAs appear to “wiggle” or appear “curlier” than the EMAs and SMAs used in previous examples.
This “wiggle” is caused by higher trading volumes at these points, which makes the VWMA react faster. In this manner, the VWMAs can sometimes create a golden cross signal earlier than the other MAs.
So, all of you traders out there that would like to enter a trade somewhat early, the VWMA could be a method you add to your toolkit to give you a slight edge over other traders.
Strategy #3 - VWMA + SMA Golden Cross Trading
The next trading strategy in my opinion is the most reliable of the methods discussed thus far.
Here I suggest you use a simple moving average as your slower moving average and a VWMA as your fast line.
In this manner, we will use a 50-period VWMA and a 200-period SMA. Since the faster MA is a VWMA, it will be even more sensitive due to higher trading volumes. I believe this is a good approach since it is the trigger MA – the one which creates the golden cross.
Bullish Cross-VWMA-SMA
The blue line on the chart is the 50-period volume weighted moving average. The red line is the 200-period simple moving average.
Notice that we have a third moving average on the chart. This is a 50-period simple moving average.
We have placed this MA on the chart, just so we can see the difference between the VWMA and the SMA signals.
As you see, the blue and the yellow lines differ slightly because the VWMA also reacts to trading volumes.
The entry of the trade comes when the blue 50-period VWMA breaks the red 200-period SMA. This creates a bullish golden cross on the chart.
See that the 50-period SMA (yellow) reacts slower to the price action. In this manner, this indicator would have placed us into the trade later, which would have cost us part of the bullish price move.
The price then enters a deep bullish trend. On the way up, the red and the blue MAs pretty much move together in harmony.
The price then decreases the intensity of its bullish move. Suddenly, the bullish trend is interrupted and the stock breaks through the red 200-period SMA. At the same time, the 50-period VWMA also breaks the 200-period SMA, creating a bearish golden cross. This creates an exit signal from our trade.
Notice how the 50-period SMA takes more time to break the 200-period SMA.
The good thing is that while the VWMA provides an earlier signal, it’s not so early that you may jump the gun before the SMA makes a cross higher. Therefore, this could give you a slight edge over the other traders or are waiting for further confirmation before opening the trade.
Lastly, since the VWMA is based on trading volume, I think it’s safe to say that volume is always a great indicator of where price will ultimately go for the short-term.
The one item we did not cover in this article is when to place a stop loss. Assuming you will not stay in the market 100%, you will need to determine when it’s time to exit the trade.
A simple approach could be to use the most recent swing low as a point to get off the bus if things start to go against you.
Conclusion
The golden cross formed by two moving averages. When the faster moving average breaks a slower moving average, we get the golden cross signal.
The most common moving averages for trading the golden cross pattern is by using:
50-period MA as a faster moving average
200-period MA as a slower moving average
There are two types of golden cross indicators passed on their potential:
Bullish Golden Cross – occurs when the faster MA breaks the slower MA upwards. This creates a bullish signal on the chart.
Bearish Golden Cross (Death Cross) – occurs when the faster MA breaks the slower MA downwards. This creates a bearish signal on the chart.
Three other averages you can use to spot a Golden Cross:
50-period EMA + 200-period EMA: The EMA indicator has the same functions as the SMA, but it places emphasis on the more recent periods.
50-period VWMA + 200-period VWMA: The VWMA indicator differs by placing emphasis on periods with higher trading volume.
50-period VWMA + 200-period SMA: The VWMA will react better to important price impulses, while the SMA will give you a peak into what the “herd” is up to. This method will provide you a slightly earlier trade signal versus using two SMAs.
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