Technical indicator is the heart of trading for those whose method of trading is technical analysis.
These indicators are important whether you day trade or swing trade. The main goal of technical analysis is to predict the future price movement. Understanding the art of trading patterns and indicators will further help you in understanding about this indicator.
Taking a step further technical indicator is further divided into: Leading and Lagging indicators.
In this article, we are going to jump into both types of indicators and identify which one fits your trading style:
What is a Leading Technical Indicator?
Leading indicators are designed in order to anticipate further price movements to give the trader an edge in trading.
Leading indicators provide early signal of entry or exit and allow more opportunities to trade. They indicate price momentum over a number of periods which is used to calculate the indicator.
Some of the well known leading indicators are:
Volume tend to show changes even before prices as it is truly represent the buying and selling pressures in the market.
If you closely analyze price and volume we can from the first marked are that the volume begins to fall. In the second volume downfall, for someone who viewed the chart without volume would easily make that the trend has reversed however, the selling pressure in the stock continues.
What is a Lagging Technical Indicator?
Lagging indicators are indicators which follow a trend then predicting price reversals. It follows an event.
These indicators work well when the prices move in long trends.
They don’t signal upcoming changes in prices buy simply tell whether the prices are increasing or decreasing so that we can invest accordingly.
Even with the delayed feedback, many people prefer to choose lagging indicators which help them to trade with more confidence by validating their results.
Usually traders use more than two or more lagging indicators to confirm the price trends before entering the stock.
Moving Averages and Moving Average Convergence and Divergence are examples of trend following or lagging indicators.
Let us take an example:
A classic example of lagging indicator set up is a 50 period 200 period moving average.
Generally a security is said to be bearish when the 50 MA crosses below the 200 SMA. Similarly a security is said to bullish when the 50 MA crosses above the 200 SMA.
In the above chart, notice the signals generated by bullish and bearish crossovers of the 200 and 50 period moving averages. In the first signal if we had short after the bearish signal then it would have been a losing trade.
The main reason behind this is that by time price moved lower and SMA’s reacted, price already fell significantly and reversed.
Then we get a signal of bullish crossover. But by the time it signals, the uptrend has already started. This signal however worked in favour.
If a trader had followed the third bearish signal and went short then it would once again trigger a loss.
The above example shows that despite lagging, one cannot trust the signals given by this indicator.
Difference between Leading and Lagging Technical Indicator?
Leading Indicators give trade signals when the trend is about to start whereas lagging indicators are those which following price actions.
Best Time Periods
Leading indicators try to predict price by using shorter period timeframe and therefore lead the price movements.
Lagging Indicators give the signal after the trend or reversals. One can use them to determine the trend.
Both leading and lagging indicators have their own set of drawbacks.
Leading indicators tend to react to the prices quickly which mean they are prone to false signals.
Lagging indicators are slow to react and they can also give false signals.
Combining Leading and Lagging Technical Indicators
Let’s see how a trader can use both leading and lagging indicators in order to gain a better view of the market.
The following shows a chart with the Relative Strength Index (leading) and two moving averages (lagging) indicators:
Here on the chart, we first notice a bearish divergence identified by price making a higher high while the 14 period RSI makes a lower low. This bearish indicator is a leading indicator which informs the trader of a potential bearish trend.
You can also see that after the leasing indicator signalled a bearish trend, it is confirmed by the moving average bearish crossovers.
You can see how simple yet powerful is it to combine both leading and lagging indicators.
Leading vs. Lagging Indicator – Which is Better?
For traders it is often difficult to balance between using leading and lagging indicators.
If you rely solely on leading indicators, chances are there to see lot of false signals.
If you rely solely on lagging indicators, chances are there to see lot of false signals.
With the above drawbacks, it is best to develop a trading strategy using both these leading and lagging indicators.
At the end of the day it is upon the trader, how he/she wants to trade!
- Leading indicators are designed in order to anticipate further price movements to give the trader an edge in trading
- Lagging indicators are indicators which follow a trend then predicting price reversals. It follows an event.
- One should not solely rely on both these indicators
- One should set up a trading strategy using both these indicators.