Golden Cross Technical indicator explained by Vivek Sharma, Estee Group

Trading has witnessed a huge spike in the past couple of years. Trading platforms are offering features to use technical indicators as screeners to narrow down trading opportunities. This behavioral shift led to an important question, how good are these technical indicators when it comes to outperforming the index or how did they fare in comparison to the index performance?

A lot of traders and investors rely on technical indicators to make buy or sell decisions. Due to the popularity of technical indicators, many analysts also use technical indicators in their analysis to give Buy and Sell calls.

Unlike fundamental analysis, where we evaluate a company’s business, results, management team, etc, in the technical analysis we study price and volume data to make buy/sell decisions.

In this article, let's look at the backtesting of one of the most popular indicators people use, the golden cross.

Golden cross indicator uses two moving averages timeframes, one long-term, and another short-term.

A moving average is one that simply averages the closing price of a stock from the current day all the way back to the specified number of days. The goal of a moving average is to smooth out changes in the price of a stock over a specified period.

Due to its simplicity, it is one of the most popular indicators used by swing investors and traders to enter and exit positions.

In the figure below, the short-term moving average is shown in blue and the longer-term moving average is shown in white.

A buy signal is generated when the short-term moving average crosses the long-term moving average from below.

A sell signal is generated when the short-term moving average comes below the long-term moving average.

Image Courtesy: gulaq.com

For this study, we took Nifty 50 stocks data for the last 6 years. We took 30 days as the short-term timeframe and 120 days as the long-term timeframe.

During these 6 years from 2016 to 2022, Nifty 50 generated 136% returns overall, with a sharp ratio of 1.84. Sharpe ratio measures risk-adjusted returns. The higher the Sharpe ratio, the better is the risk-adjusted returns.

In the same 6-year period, had one been following a Golden Cross strategy on Nifty, he would have made only 70% returns.

If one were to follow Golden Cross on Nifty 50 stocks, even then the strategy underperformed drastically.

The mean returns for all 50 stocks was 35% 6 years with a sharpe of just 0.06.

In the chart below, P&L of all the 50 stocks is shown in descending order. We can see that only half of the stocks returned positive returns. There is a 52% probability of being profitable if you invest in any random day, and the probability improves if one holds the positions longer. When you see half of the stocks returning negative returns after a 6 year holding period based on a technical indicator, you can understand the quality of the strategy deployed.

There were just 5 stocks out of total 50, where the strategy performed better than the buy-and-hold returns of Nifty. Additionally, the risk-adjusted returns (sharpe) in each of these 5 cases was lower than the buy and hold sharpe of 1.84.

Image Courtesy: Vivek Sharma

We tend to pick technical indicators based on their recent performance, typically the last year's performance. Hence, we have expanded our research to explore this case.

What happens if we try to select the stocks which have given good returns in the past 1 year in the same strategy.

We filtered those stocks for which Golden Cross has been giving good returns in the past one year and excluded all the stocks for which the Golden Cross strategy hasn’t worked in the past 1 year.

Even if we filter stocks based on the past 1-year returns from the Golden Cross strategy, it was found that the previous year’s returns had a negative correlation to the next year expected returns. Essentially, if you had picked a technical indicator based on its performance last year, it is likely that you would be disappointed with your expectations.

Image Courtesy: Vivek Sharma

Conclusion:

Making money and outperforming the benchmark requires a much more nuanced approach to stock and strategy selection, than just simply using an off-the-shelf technical indicator and using it. As with the Golden cross signal, most of the other technical indicators also won’t be able to outperform the buy-and-hold strategy in the Index. Next time you see a random trader talking about how he/she multiplied wealth by a technical indicator, please do not get carried away.

Vivek Sharma, director (strategy) and head of investments at Gulaq, a part of Estee Group