Learn how to use the moving average 'golden cross' to confirm changes in price trends, and as a reliable signal for trade entries.

A golden cross is a technical trading strategy which occurs when a short-term moving average crosses the path of a longer-term moving average.

The moving average is an indicator that measures the average movement of an asset price over time. When a short-term moving average crosses above a longer-term moving average, it is a confirmation of upward momentum, and when the short-term average crosses below the longer-term average it confirms downward momentum.

The Australia 200

Below we have a chart of the Australia 200 with two indicators – the green one is the 20-day moving average and the red one is the 50-day moving average. As you can see, the Australia 200 hit a low of 4,432 on July 19 before starting to trend up again.

On July 20, the 20-day moving average crossed above the 50-day moving average, signalling that it was time to go long. You decided to open a long position on two contracts at 4,527.6, valued at $25 per point movement.

As the golden cross is a confirmation of an existing trend, the signal that the index is now trending down won’t occur until after the market has turned. So, as part of this strategy, you set a trailing stop* at 20 points – this stop will follow the market up, and will then automatically close you out of the trade should the index fall by 20 points.

After reaching a high of 4,630.5, your stop loss was triggered at 4,610.5 on July 22, securing you $4,145 ([4,610.5 – 4,527.6] x $25 x 2 contracts = $4,145) in profit.**

As you can see, the 20-day moving average crosses below the 50-day moving average late on July 27, indicating that now the market is going to start heading down. At this point you could open a short position on the index; again using a trailing stop to close your position should the market start heading up.

Conclusions on using the golden cross

The main advantage of using the golden cross is that you are joining an established trend, meaning that, assuming you use adequate risk management, there is a high probability of making a profit. However, as this method confirms an existing trend rather than predicting an impending one, there is a chance that you may enter the trend late and miss a lot of the profit-taking.

The example above worked quite well; however, you didn’t make as much of a profit as someone who entered a long position at the July 19 low of 4,432.5 before the market turned up.

Also, an indicator should be sensitive to price movements and give early signals. One weakness of indicators is that they are more sensitive over short periods, but give more false signals over shorter periods. In the example above we used 50-day and 20-day moving averages on a one-hour chart. This resulted in good signals being delivered, but few signals were delivered and they were triggered quite late (nearly 80 points after the index actually turned).

In contrast, if we had used a 15-minute chart with 14-day and 7-day moving averages, we would have had more frequent signals and a greater response to price movements, but there would have been so many signals that few of them would have indicated a lasting trend, as shown below.

*Due to the leveraged nature of CFDs, CFD providers offer a range of risk management tools including guaranteed stop losses, trailing stops and limit orders. It pays to research the offerings of different CFD providers, as these can vary from broker to broker.

**Stock index contracts traded as CFDs are usually commission free, as most indices are charged based on the spread.

This information has been prepared by Jacqueline Pretty at IG Markets Limited (ABN 84 099 019 851) (AFSL 220440). No representation or warranty is given as to the accuracy or completeness of the above information, consequently any person acting on it does so entirely at his or her own risk. IG Markets accepts no responsibility for any use that may be made of these comments and for any consequences that result.