About that Death Cross in the Russell IWM…

I’ve been hearing a lot of discussion about the “Death Cross” in the Russell 2000, particularly in the IWM ETF.

Let’s identify what a “Death Cross” is and then test out prior performance of “Death Crosses” specifically in the IWM Russell 2000 ETF.

Here’s a current chart – and we’ll step inside it all shortly:

First, let’s define a “Death Cross.”

A “Death Cross” – that’s such an ominous sounding name – occurs by definition when the 50 day Simple Moving Average (SMA) crosses under the 200 day Simple Moving Average.

It simply means that a shorter-term moving average has crossed under a longer term moving average.

A Moving Average adds the closing price of every day – for example 50 days – and then divides that number by 50 days (or however many days have been added).

The goal is to find the “average” price over that period and we plot this on the chart as a line which we call a “Moving Average.”

That being said, when a shorter-term average crosses under a longer-term average, it could signal a trend change in price.

As such, we can program a strategy to short-sell the market when the 50 day average crosses under the 200 day average, or also buy the market when the shorter-term average crosses above the longer-term average.

In the chart above, I’ve done exactly that using TradeStation and initiated a strategy BUY when the 50 day SMA crosses above the 200 day SMA and then a short-sale (flip and reverse) when the 50 day SMA crosses under the 200 day SMA.

The Green and Red lines above simply connect the price-based entries on the chart (green is for when the trade made money; red is for when it lost money).

We can see that currently, we remain on a “Buy Signal” from mid-2012 and we hear the chatter about the potential “Sell Signal” that may trigger soon if price does trade lower and the 50 day SMA does go on to cross under the rising 200 day SMA.

For reference, I plotted the 50 day SMA as BLUE and the 200 day SMA as RED.

Let’s zoom-in on the price and strategy action:

We see the period from the market bottom (March 2009) until the beginning of 2012 to clarify the cross-overs (signals) during this period.

There were TWO Death Cross signals during this time:

July 29, 2010 and August 15, 2011

You can see these on the chart above with the red box.

Both times, the market went on to trade higher to continue the uptrend – price did not reverse – and thus both trades were closed at a loss (black line).

I would like us to take a closer look at the 2010 period to learn a valuable lesson about Moving Average Crossover Strategies (and Analysis):

Here are those same two Death Cross signals – red lines – and the outcome.

This time we can see the price action clearly and let’s focus our attention on something you don’t see until you actually trade these strategies.

Notice the distance price is trading away from the averages when they cross-over.

For example, during the Bullish (also called “Golden”) Cross on October 26th, price was roughly $ 5.00 above the cross-over point near $ 65.50.

I think this distance or conundrum is clearer when studying the “Death Cross” Signal that triggered on August 15, 2011.

Price literally collapsed from the $ 84.00 per share level all the way down to $ 64.00 BEFORE the moving averages generated its official “Sell Me Now” signal with the Death Cross.

The short-sale trade officially triggered near $ 70.00 per share.

Yes, price did trade lower all the way to $ 60.00 per share but there isn’t a way to use moving averages to “call a bottom” (or a top, for that matter) using this strategy.

In fact, even though the market did trade lower, the “reverse and exit” signal triggered when the averages crossed bullishly – the Golden Cross – on February 9, 2012.

If you look closely at the chart, we see that the official exit price at the $ 83.00 per share was clearly ABOVE the cross-over signal then intersecting the $ 76.00 level.

Here’s the main idea about Moving Average Cross-over Strategies:

They experience significant delay.

Remember that price has to move BEFORE the average can turn up or turn down, and in order to generate a signal from a shorter-term average crossing a longer-term average, price often has to move a considerable distance.

In other words, don’t get too excited when you see official moving average cross-over signals.

My advice is to use them more for analytical (analysis) purposes rather than as stand-alone trading signals or programs.

It can be interesting – and it is – to talk about Death and Golden Crosses, but do your research before using these as independent trading strategies.

Follow along with members of the Daily Commentary and Idealized Trades summaries for real-time updates and additional trade planning.

Corey Rosenbloom, CMT

Afraid to Trade.com

Follow Corey on Twitter: http://ift.tt/178Lhrq

Corey’s book The Complete Trading Course (Wiley Finance) is now available along with the newly released Profiting from the Life Cycle of a Stock Trend presentation (also from Wiley).

Afraid to Trade.com Blog

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