The Death Cross - How To Trade It

[jswanson 10]

In mid-August of this year (2011) there were many people pointing out the newly formed “Death Cross” in the major indices. The Death Cross is simply when a 50-period simple moving average (SMA) crosses under a 200-period SMA on a daily chart. Such a signal is believed to warn of upcoming bearish market activity. The opposite signal is called a “Golden Cross” and is alleged to warn of bullish market activity. But does the Death Cross or the Golden Cross hold any merit? What can we learn from these signals and how can we use this information in our trading? In this article I’m going to demonstrate why the Death Cross is important and why its opposite signal, the Golden Cross, may be even more important.

 

Both the 50-period SMA and the 200-period SMA are well known moving averages. Thus a lot of eyes are watching price around these levels. It’s no surprise when these moving averages cross the event might be worth noting. One way to test how well the Death Cross and Golden Cross perform historically is to create a simple trading system based upon these signals. Using TradeStation’s EasyLanguage coding language it’s simple to create a trading system that is always in the market switching between a long position and a short position based upon a moving average crossover. Here is what the entire trading system code looks like:

 

if ( Average(Close,50) crosses above Average(Close,200) ) then
buy(“Golden Cross”) next bar at open;
if ( Average(Close,50) crosses under Average(Close,200) ) then
Sell short(“Death Cross”) next bar at open;

 

In order to get a long-term feel for this system I’m going to use the S&P500 index going back to 1961. The trading system will have an initial trading account size of $20,000. To keep the position sizing simple each signal will use $10,000 to determine the number of shares to purchase. By dedicating $10,000 to each trade we are attempting to normalize the number of shares we purchase based upon the cost per share. Back in the 1960s one share was around $70 while today it’s worth over $1,000.

 

Next, I opened a chart with daily data for the S&P E-mini from 1961 to September 30, 2011. I then applied the strategy to the chart while making no deductions for commissions and slippage.

 

Before we start looking at some of the numbers I want to break this study into two parts: Shorting a Death Cross vs. going long the Golden Cross. What interests me is how well the system functions going long vs going short. In other words, what does the SMA cross tell us about a bearish cross vs a bullish cross? Are they different?

Since we recently experienced a Death Cross, let’s first look at shorting every Death Cross signal. The equity graph is below and it’s not pretty.

 

SHORTING THE DEATH CROSS

 

 

What does this tell us? To simply short the Death Cross may not be very profitable. We can see the equity curve hangs around the zero line for decades. In recent times it has climbed from negative territory to just below the zero line. Yet, there is nothing in this picture that suggests we have an edge simply shorting the S&P index upon a Death Cross signal.

 

Maybe we should be taking the Death Cross as a buying opportunity? Why not? We want to be opposite the crowd, right? Below is the equity graph when we go-long at every Death Cross.

 

GOING LONG THE DEATH CROSS

 

 

Interesting! At times going long actually makes money and notice how the equity graph spends a lot of its time above the zero line. Furthermore, unlike shorting the Death Cross, going long actually produces a positive result. Counter intuitive to common knowledge, I would say. Yet, it’s not much of a profit for all those years of trading and it’s certainly not an edge we can take advantage of. All in all this strategy is a wash much like shorting the Death Cross. This graph probably reflects the fact that the S&P 500 has had a bullish bias since 1961. It also points to the idea that during a Death Cross we have continued market weakness. In other words, market gains are not likely to happen when the 50-period SMA is below the 200-day SMA.

 

Next let’s look at taking every long signal. The equity graph below depicts going long at each Golden Cross.

 

GOING LONG THE GOLDEN CROSS

 

 

This is a much improved equity graph! We seem to have a clear edge going long the S&P 500 when a Golden Cross is triggered. This graph highlights the fact that when the 50-period SMA is above the 200-day SMA the market often exhibits bullish behavior.

Combining what we have now learned I would say our two equity graphs above might be suggesting moving your investing accounts into cash when a Death Cross forms may be a good idea. This would be done in my opinion to prevent drawdown and thus avoid the pain seeing your profits evaporate. It’s certainly can be much more psychologically appealing to be in cash when those big bear markets hit. Shorting a Death Cross does not have much of an edge and only after a Golden Cross does the market hold a strong bullish edge.

 

The chart below shows each trading system with the addition of a buy-and-hold approach.

 

 

You can see the market has had a clear up-side bias since 1960 and buying and holding produced the best annualized return. But at what cost? The drawdowns you must live through can be substantial! The maximum intra-day drawdown, expressed, in terms of your initial capital is 777%. While buy and hold has worked wonders if you started in 1961 it has not done well over the past 15 years. Over the past 15 years the buy and hold has returned a zero annualized return while the long-Golden Cross has returned around 2% annual return over the same period. But the advantages and disadvantages of buy-and-hold are for another topic.

 

SUMMARY:

 

By comparing the market behavior during a Death Cross vs a Golden Cross we can come to some generalizations that might help in both your investing accounts as well as your trading accounts (depending upon your timeframe).

 

* Upon a Death Cross signal the market shows general weakness to the upside. This weakness can be difficult to short. Moving into cash during this time may prevent you from experiencing significant drawdowns. Remember, we are not talking about day trading in this article. The Death Cross and Golden Cross are based on slow moving averages that work best for long term holding periods. A skilled day trader can make a lot of money shorting during a bear market, of course. However, when it comes to using a slow timing method such as the Death Cross, it does not seem to pay off.

 

* Upon a Golden Cross signal the market has demonstrated a lot of bullish activity. This one is easy. When a Golden Cross occurs, going long the market may lead to strong gains over the coming months and years.

[guyber 10]

Hi jswanson,

 

Thanks - that is very interesting and nicely laid out.

 

Can I ask what signal you use to exit each position? Eg is it one of the two moving averages crossing back over, or one (or both) turning negative (or positive) or is it for a fixed period of time.

[jswanson 10]

  guyber said:

Hi jswanson,

 

Thanks - that is very interesting and nicely laid out.

 

Can I ask what signal you use to exit each position? Eg is it one of the two moving averages crossing back over, or one (or both) turning negative (or positive) or is it for a fixed period of time.

 

Thanks. The entry/exit was simply when the 50-period SMA crosses the 200-period SMA.