Quick Answer
Moving averages smooth price data and generate golden-cross (bullish) and death-cross (bearish) signals when the short-term average crosses the long-term average. Overbought and oversold conditions flag potential reversals without guaranteeing one, and volume should confirm both breakouts and the prevailing trend.
What Are Moving Averages?
A moving average (MA) smooths out price data to identify the direction of a trend.
- Simple moving average (SMA): Average of closing prices over a specified number of periods (e.g., 50-day, 200-day)
- The 200-day moving average is widely watched as a long-term trend indicator
Golden Cross and Death Cross
| Signal | What Happens | Interpretation |
|---|---|---|
| Golden cross | Short-term MA crosses above long-term MA | Bullish signal - upward momentum is building |
| Death cross | Short-term MA crosses below long-term MA | Bearish signal - downward momentum is building |
- Typically uses the 50-day MA (short-term) and the 200-day MA (long-term)
- A golden cross suggests the beginning of a potential long-term uptrend
- A death cross suggests the beginning of a potential long-term downtrend
- These signals are more reliable when confirmed by high trading volume
Exam Tip: Gotchas
- Golden cross = bullish (short-term MA crosses ABOVE long-term MA)
- Death cross = bearish (short-term MA crosses BELOW long-term MA)
What Are Overbought and Oversold Conditions?
| Condition | Description | Implication |
|---|---|---|
| Overbought | Prices have risen too far, too fast; buying pressure is exhausting | Stock or market is due for a pullback or correction |
| Oversold | Prices have fallen too far, too fast; selling pressure is exhausting | Stock or market is due for a bounce or recovery |
- These conditions help identify potential reversal points
- Important caveat: prices can remain overbought or oversold for extended periods; the condition does not guarantee an immediate reversal
Exam Tip: Gotchas
- Overbought does NOT mean "sell immediately." Prices can stay overbought for a long time.
What Is a Breakout?
- A breakout occurs when price moves above resistance or below support with conviction
- Volume confirmation: A breakout accompanied by high volume is more reliable than one on low volume
- A false breakout (failed breakout) occurs when price briefly penetrates support or resistance but then reverses back
- False breakouts can trap traders who acted too early
Exam Tip: Gotchas
- A breakout without volume confirmation is suspect (potential false breakout).
How Do You Read Volume?
Volume should confirm the price trend. Interpretation depends on the market condition:
In an Uptrend (Healthy)
- Rising volume on up days: buyers are actively participating
- Declining volume on down days: sellers are not aggressive
In a Downtrend (Healthy)
- Rising volume on down days: sellers are actively participating
- Declining volume on up days: buyers are not aggressive
Divergence Warning
- When price moves in one direction but volume moves in the opposite direction, it signals a potential trend reversal
- Example: prices making new highs on declining volume = weakening trend (bearish divergence)
Exam Tip: Gotchas
- Volume should CONFIRM the trend. Rising volume in an uptrend is healthy; declining volume in an uptrend is a warning sign.
What Should You Check on Exam Day?
- Golden cross (short-term MA crosses above long-term MA) is bullish; death cross (crosses below) is bearish.
- Typically the 50-day (short-term) and 200-day (long-term) moving averages form the golden-cross/death-cross pair.
- Overbought and oversold conditions do not guarantee an immediate reversal.
- A breakout without volume confirmation is a warning sign of a possible false breakout.
- Rising volume on up days in an uptrend (or down days in a downtrend) is healthy; divergence between price and volume warns of a reversal.