Leading vs. Lagging Indicators
We’ve already covered a lot of tools that can help you analyze potential trending and range-bound trade opportunities.
Still doing great so far? Awesome! Let’s move on.
In this lesson, we’re going to streamline your use of these chart indicators.
Let’s discuss some concepts first. There are two types of indicators: leading and lagging.
A leading indicator gives a signal before the new trend or reversal occurs.
A lagging indicator gives a signal after the trend has started and basically informs you “Hey buddy, pay attention, the trend has started and you’re missing the boat.”
You would “catch” the entire trend every single time IF the leading indicator was correct every single time. But it won’t be.
When you use leading indicators, you will experience a lot of fakeouts. Leading indicators are notorious for giving bogus signals which could “mislead” you.
Get it? Leading indicators that “mislead” you?
Haha. Man, we’re so funny we even crack ourselves up.
The other option is to use lagging indicators, which aren’t as prone to bogus signals.
Lagging indicators only give signals after the price change is clearly forming a trend. The downside is that you’d be a little late in entering a position.
It’s kinda like wearing bell-bottoms in the 1980s and thinking you’re so cool and hip with fashion….
It’s kinda like using discovering MySpace for the first time when all your friends are already on Facebook…
It’s kinda like getting excited buying a new flip phone that now takes photos when the iPhone 7 came out…
For the purpose of this lesson, let’s broadly categorize all of our technical indicators into one of two categories:
- Leading indicators or oscillators
- Lagging or trend-following indicators
While the two can be supportive of each other, they’re more likely to conflict with each other.
We’re not saying that one or the other should be used exclusively, but you must understand the potential pitfalls of each.
Should You Be Using Lagging Or Leading Chart Indicators?
by Tyler Yell, CMT , Forex Trading Instructor
Position Trading based on technical set ups, Risk Management & Trader Psychology.
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Article Summary: Many traders learn to use the indicators that are based on past price action to develop a trading plan. While many of these indictors have their place, there are other indicators that help you see where price is likely to stop before the time arrives. Naturally, this can be a very useful tool in your trading.
“If past history was all there was to the game, the richest people would be librarians.”
When a new trader decides to incorporate charting into their trading, they often don’t know where to start. Most often, a quick search of how to find opportunities on the charts will lead you to the more popular indicators like a moving average, relative strength index or RSI, the moving average convergence divergence or MACD, or a Stochastic type indicator that shows you how markets oscillate up and down. The common thread of these types indicators is that they use a recent close of past price candles to hopefully anticipate immediate action to follow.
There is nothing wrong with looking at the last several periods in the market to determine aspects like whether the markets are trending or ranging. That is the often the best method to get the context for what is most likely the current state of the market. However, entering trades may be better done through price reacting to a leading indicator.
Learn Forex: Moving Averages Can Give Context But Aren’t Predictive By Their Nature
There are a handful of leading indicators that could not be given their due justice here. However, it’s important to know of the popular ones so that you can find one that works well with your current form of analysis. The basic function of a leading indicator is to help you see how price could unfold.
Pivot points are a personal favorite because they are the most objective of leading indicators. Pivot points are taken from critical past price points and then a calculation is plotted on the chart to give you three key levels. The pivot point sits in the middle of the calculations with resistance points or profit targets for buy trades above the pivot point and support or profit targets on sell trades. Therefore, if you believe EURUSD is likely to move higher you could target the green resistance levels and put a stop below the lower support level that matches your risk management rules.
Learn Forex: Pivots give you objective points to target with your trade.
Elliott Wave is a theory about the market in how trends and corrections unfold. The main arguments are that a trend subdivides into 5 waves with each wave displaying distinct characteristics. The leading nature of Elliott Wave comes in its use of Fibonacci ratios. If you’re unfamiliar with how to trade Fibonacci relationships, you can register for this FREE online course HERE . One common ratio that is used to define a profit target is that wave 5 often travels 61.8% of the distance covered in waves 1-3.
Learn Forex: Elliott Wave is very helpful for gathering context of the market
Trading with sentiment may seem counter intuitive at first. That is because a trading signal comes from reading sentiment by taking a trade in the direction of the trend but is opposite against the majority of traders or investors. Therefore, if there is a strong uptrend but the majority of traders are short or selling, then you would look to enter against the majority and trade in the direction of the trend.
Learn Forex: Don’t Fight the Trend & Don’t Follow the Herd
The reason that sentiment is considered a leading indicator is that it is used on the premise that all things being equal, a trend will continue and traders who are fighting the trend will only prolong its existence as they exit their trades against the trends to prevent themselves from losing more capital.
Learn Forex: IG Client Sentiment is our Sentiment Tool of Choice
Presented by dailyfx.com/technical_analysis/sentiment
The IG Client Sentiment or IGCS is updated once a day for DailyFX. Otherwise, it is updated once a week. This information can be very helpful in giving you an edge during a strong trend.
There are no perfect indicators. By their nature, an indicator will help you see likely outcomes; however, you shouldn’t seek certainty because it does not exist within indicators. Leading indicators can be a helpful addition once you know how to use them to capture an edge in your trading and hopefully this article has made you more comfortable in accessing these great options.
-Written by Tyler Yell, Trading Instructor
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Exploring Oscillators and Indicators: Leading And Lagging Indicators
Indicators can be separated into two main types - leading and lagging - both differing in what they show users.
Leading indicators are those created to precede the price movements of a security giving predictive qualities.
Two of the most well-known leading indicators are the Relative Strength Index (RSI) and the Stochastics Oscillator.
We will cover the RSI indicator in more detail later on in this tutorial, but for now to get an idea of how it can be used as a leading indicator, take a look at the chart of International Business Machines (IBM) shown below. Notice how the RSI indicator shown at the top of the chart is trending upward while the price of the stock was moving lower. Active traders who were able to spot the divergence between the indicator and the underlying price were able to open a position before the move higher occurred. Entering a position early, or leading a move before others are able to determine what is going on is the primary goal of many who use technical analysis .
The majority of leading indicators are oscillators. This means that these indicators are plotted within a bounded range. The oscillator will fluctuate into overbought and oversold conditions based on set levels based on the specific oscillator.
Note: An example of an oscillator is the RSI, shown above, which varies between zero and 100. A security is traditionally regarded as overvalued when the RSI is above 70 and oversold when the RSI is below 30. In the case of IBM, you can see how overbought and oversold readings would have allowed traders to anticipate major changes in the price of the company’s shares before the rest of the market took notice.
A lagging indicator is one that follows price movements and has less predictive qualities. The most well-known lagging indicators are the moving averages and Bollinger Bands®. The usefulness of these indicators tends to be lower during non-trending periods but highly useful during trending periods. This is due to the fact that lagging indicators tend to focus more on the trend and produce fewer buy-and-sell signals. This allows the trader to capture more of the trend instead of being forced out of their position based on the volatile nature of the leading indicators.
How Indicators Are Used
The two main ways that indicators are used to form buy and sell signals are through crossovers and divergence.
Crossovers occur when the indicator moves through an important level or a moving average of the indicator. It signals that the trend in the indicator is shifting and that this trend shift will lead to a certain movement in the price of the underlying security.
For example, by taking a look at the chart of Nike Inc. (NKE), you can see that the crossover between the 50-day and 200-day moving averages (shown by the blue circle was a clear signal of the beginning of a major uptrend. (For more on this topic, check out: How To Use A Moving Average To Buy Stocks)
The second way indicators are used is through divergence, which was shown in the example of IBM above. Divergence occurs when the direction of the price trend and the direction of the indicator trend are moving in the opposite direction. This signals that the direction of the price trend may be weakening as the underlying momentum is changing.
There are two types of divergence - positive and negative. Positive divergence occurs when the indicator is trending upward while the security is trending downward. Positive divergence is the type of divergence shown on the chart of IBM above and is a bullish signal that suggests the underlying momentum is starting to reverse and that traders may soon start to see the result of the change in the price of the security. Negative divergence works in the opposite manner and occurs when an indicator starts to trend lower while the price of the underlying security trends upward. Negative divergence is a popular bearish signal that is used by traders for identifying periods where momentum is weakening during an uptrend.
For example, notice on the chart of Biogen Inc. (BIIB) below, that the relative strength index was trending downward while the security's price was trending upward. This negative divergence would be used to suggest that even though the price was lagging the underlying strength, based on the RSI, traders would still expect to see bears control of the asset's direction and have it conform to the momentum predicted by the indicator.
Indicators that are used in technical analysis provide an extremely useful source of additional information. These indicators help identify momentum, trends, volatility and various other aspects in a security to aid traders when making decisions. It is important to note that while some traders use a single indicator solely for buy and sell signals they are best used in conjunction with price movement, chart patterns, and other indicators. (For related reading, see Technical Analysis Strategies for Beginners)