Moving averages are used by many traders to identify trends as they smooth out price action and act as key support on the way up, and resistance on the way down. In fact, it is one of the most widely used technical indicators and extremely popular among high frequency traders because it is so clear cut and easy to program. It allows the trader to ride a trend higher and to cut losses short.
The death cross is a popular signal that when used properly can cut massive losses short. The death cross is so popular because many institutional investors use the 50 day moving average as a medium term average and the 200 day as the long term moving average. Basically, the crossover method signals a sell signal when the shorter term moving average crosses the longer term moving average to the downside. A buy signal is identified when the short term moving average crosses the long term average on the upside.
Crossover methods are easy to program into a computer. However, I must warn that one must use additional clues to create a sell signal. There are frequent whipsaws and failures when you use the crossover method in isolation.
Chart reading is an art that requires discipline, experience and study. Crossover methods used exclusively, such as by a computer program, will not produce the same results of an experienced technician who looks for other pieces of evidence to confirm the bearish crossover.
Similarly, back testing the results of the death cross using a computer program will not produce optimal results, since technicians look for additional signs of the breakdown than just the cross. I was recently interviewed by the Toronto Globe and Mail on this topic and explained that one must be aware of this crossover and its implications.
Although some believe this signal is nonsense, and show back-tested data with computer models, it does not show the crossovers used in conjunction with other technical signals.
If the crossover signal is confirmed with a head and shoulders breakdown, a cross into new lows, and poor price volume action, which is occurring now, I will patiently wait on the sidelines and look for prudent short points when I see a price reversal and as the price comes up to certain resistance. If all these signs are coming together the probability of a whipsaw is significantly reduced.
It is also important to note that a death cross is further confirmed if the 200 day begins sloping downwards after the break. This will act as resistance on the way down.
A look at the death cross of the Dow in January of 2008 showed many of the signs of a market top and trend change.
The 200 day which acted as previous support was violated on high volume and was followed by three failed railies at the 50 day moving average before crossing over. If not followed investors would have lost more than 60% of their portfolios.
Now is not the time to look for bargains but to protect your portfolio by selling on any bear rallies.
I believe that this rally will be shortly coming to an end and we will continue to trend lower in equities. Use these rallies to prepare for shorting opportunities.
Disclosure: Not currently shorting or investing in inverse etf's at the time of writing this article.