How to Play the Death Cross From Both Sides

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How to Play the Death Cross From Both Sides

By Jonathan Rodriguez, Senior Analyst

On Monday, the Nasdaq Composite Index produced a “death cross” chart pattern.

A death cross forms on a stock chart when its 50-day moving average crosses below its 200-day moving average.

The Nasdaq cross follows death crosses in the other major U.S. stock indices – the S&P 500, the Dow Jones Industrial Average (DJIA), and the Russell 2000.

This market condition is often called “the Four Horsemen” or a death cross “grand slam.” And according to Brean Capital, this grand slam has happened only 13 times since 1979. Many claim this signal spells volatility and, ultimately, doom for the stock market.

But I believe a death cross is a golden opportunity. Here’s why  . . .

Short-Term Pain, Long-Term Gain

As a technical analyst, I live and breathe stock market history. And, more importantly, I follow the trends.

When the market flashes a death cross, selling to protect profits makes sense for investors with a short-term horizon. Immediately following the cross, volatility is guaranteed, as investors exit the market.

According to Bespoke Investment Group, since 1929 the S&P 500 has returned -1.38%, on average, in the one-month period following a death cross.

But here’s the thing: The death cross is a jackpot for those staying in the game.

The three-month and six-month S&P 500 returns post-cross are significantly better at 3.12% and 8.23%, respectively.

Better still, you can even play the cross as a bull and a bear.

Playing Both Sides of the Cross

To generate short-term alpha, consider buying out-of-the-money SPDR S&P 500 ETF (SPY) puts with a one to three month expiry from the start of the cross.

The caveat here is that option premiums rise with volatility – but it’s worth the tradeoff in gains as you ride the downside of the cross. If you don’t trade options, take a look at a short S&P 500 ETF like the ProShares Short S&P 500 (SH). For more aggressive investors, a 2X or 3X short S&P 500 ETF will squeeze even more profit out of your short.

Once relative strength returns to the market in a few months, close your short position and go long to capture the death cross upside.

Bottom line: As history shows, the death cross is only a death sentence if you head for the sidelines. The smart money buys the cross as everyone else sells.

On the hunt,

Jonathan Rodriguez

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By Jonathan Rodriguez