Leading and Lagging Indicators
Technical analysis is founded on the belief that watching historical price action can help forecast future price behaviour. Technical analysts typically use indicators to help them understand past price action and identify optimal price entry and exit points in the market. Technical analysis indicators are mathematical tools that help traders analyse various elements of an asset’s price, such as trend, volume, momentum, volatility, and market cycles. Numerous technical analysis indicators are available to traders, but they generally fall under two broad categories: leading and lagging.
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What is a leading indicator?
A leading indicator is designed to help traders anticipate future price action. Leading indicators basically ‘lead’ price action and deliver signals to traders before a trend or reversal happens in the market. Leading indicators could help traders capture maximum profits because they can enter a trade at the start of a price move in the market. However, because they anticipate price action, leading indicators can sometimes deliver many false signals. For instance, a leading indicator can provide a reversal signal when it is only a temporary retracement in the market.
What is a lagging indicator?
A lagging indicator is designed to help traders confirm a trend or reversal in the market. Most lagging indicators basically ‘lag’ the market and deliver signals after a trend or reversal has already started in the market. Lagging indicators help traders confirm that a trend in the market is indeed in place, and trades that are in tandem with the existing market condition can then be executed. While they are solid confirmation tools, lagging indicators tend to deliver signals late, and there might not be enough time to capture as many profits as possible. For instance, most trends make the bulk of their movement in the early stages, and a lagging indicator may deliver a signal when the trend has already done a huge leg.
Leading Indicators Examples
Here are some examples of popular leading indicators:
Relative Strength Index (RSI)
The RSI is a momentum indicator that delivers overbought and oversold signals in the market. The indicator oscillates between 0 and 100. An RSI reading of 30 and below implies that an asset is oversold, and higher prices can be expected, whereas a reading of 70 and above denotes an overbought asset where lower prices can be expected. Traders seek buying opportunities in oversold markets and selling opportunities in overbought markets.
Like the RSI, Stochastics is a momentum indicator that delivers overbought and oversold signals. The indicator oscillates between 0 and 100, with distinct lines drawn at 20 and 80. A reading below 20 indicates that a market is in oversold territory, thus, potentially cheap. Traders then seek opportunities to place buy orders because higher prices are expected. Similarly, a reading above 80 implies that a market is overbought territory, where prices are considered expensive and unsustainable. Traders will seek opportunities to place sell orders because lower prices are expected.
Support and Resistance
Support and resistance levels help traders identify market interest areas where demand and supply forces tend to shift. In these support areas, the demand for an asset will be expected to exceed its supply, and thus prices start to turn higher. Likewise, supply outstrips demand at support, and prices are expected to turn lower. Traders, therefore, seek to place buy orders at or near support areas and sell orders at or near resistance areas.
The Pivot Points indicator generates multiple support and resistance lines based on a previous period’s high, low, and close prices. Typically, there is a reference line or central pivot (PP) and three support lines (S1, S2, and S3) as well as three resistance lines (R1, R2, and R3). These lines are excellent reference levels for demand and supply in the market. In a trending market, the lines can be used as ideal areas where price pullbacks can end; whereas in ranging markets, the pivot lines serve as support and resistance areas. The Pivot point lines can also be used to time price breakouts in the market.
Donchian Channels is an envelope-type volatility indicator with a median band enclosed by an upper and lower bands. The bands are derived from the high and low prices achieved in previous periods, and they help traders assess trends and timing breakouts. The upper band measures the underlying bullish pressure in the market. The market is trending upwards when prices are hugging the upper band, and there is a bullish breakout when the upper band is breached. Similarly, there is underlying bearish pressure when prices are hugging the lower band, and a bearish breakout is confirmed when the lower band is breached. The median band can be used to take high-quality retracement opportunities in a trending market. The median band can also confirm a trend reversal when it is breached.
Lagging Indicators Examples
Here are some examples of popular lagging indicators:
Moving averages (MAs) are among the most popular technical analysis indicators. Traders use them because they smooth out price action and provide a clear visual of the trend in the market. MA’s are the average prices of an asset over a specified period. MA’s are lagging indicators because they are computed using historical prices. They are primarily used in trend-following strategies, with traders typically combining shorter period MA’s with longer period ones. For instance, a 50-period MA can be combined with a 200-period MA. When the shorter period MA crosses the longer period MA, it signals that a new trend is already in place. However, such crosses usually happen after the price has already moved considerably.
Bollinger Bands is a volatility indicator with a 20-period simple moving average and an upper and lower band with two positive and negative standard deviations of the middle line. The bands converge when there is low volatility and diverge when there is high volatility. While some traders watch the bands for potential leading signals for strategies such as breakout trading, Bollinger Bands itself does not indicate when volatility is likely to change in the market. Still, it merely reacts after the underlying price action has happened. This is why Bollinger Bands is never used in isolation, mainly combined with leading indicators such as RSI.
Average Directional Index (ADX)
ADX is an indicator used to gauge the strength of the underlying trend in the market. Traders use ADX to filter out the best trending and ranging markets to trade. ADX plots readings from 0 to 100. When ADX stays below 25 for an extended time, it is an indication that there is no clear trend, and traders can apply range-bound plays in the market. A reading of above 25 implies that a strong trend is forming. Still, ADX lags the market and is often combined with other indicators to deliver effective trading signals.
Parabolic Stop and Reverse (Parabolic SAR)
The Parabolic SAR indicator is used to follow trends and determine where reversals are likely to happen. The indicator prints dots below the price during an uptrend and dots above the price during a downtrend. But the Parabolic SAR is a lagging indicator that follows the price, and they often signal a reversal when the price has already definitively turned around. Even in a trending market, the dots are printed slowly as the price accelerates in a particular direction. Thus, Parabolic SAR is only potent when combined with other indicators such as moving averages and ADX.
The Moving Average Convergence Divergence (MACD) is a popular indicator used to determine trend direction, its strength, and a possible reversal. It features a histogram as well as a MACD line and signal. Traders watch for crossovers, divergences, and strengthening trends when trading with MACD. But because it is computed using moving averages, the MACD is inherently a lagging indicator and is often combined with oscillators such as RSI for more credible signals.
Leading Vs Lagging Indicators
Consider the market as a car to understand the relationship between leading and lagging indicators. Leading indicators are your windshield (showing you where you are going), whereas lagging indicators are your side mirrors (displaying where you are coming from). Both indicators are essential to your driving. It is always tempting for traders to focus on leading indicators because they offer ideal entry points for maximum profits but are also prone to numerous false signals. On the other hand, despite lagging indicators limiting potential profits, they provide the much-needed conviction to enter trades in the market. Therefore, a solid trading strategy will find a way to combine the two indicators in relevant market conditions effectively. For instance, RSI can identify overbought and oversold conditions on relevant Pivot Point levels.
Traders use indicators to identify the best opportunities in the market that can be exploited with as minimal risk exposure as possible. Understanding how to use and combine different leading and lagging indicators to trade efficiently is essential. Browse through the AvaTrade education section and learn the other signals from popular leading and lagging technical analysis indicators. Sign up for a free demo or live AvaTrade account now and start applying your knowledge and skills today.
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- What is a leading indicator?
A leading indicator is an indicator that aims to predict future price action and provides trading signals.
- What is a lagging indicator?
A lagging indicator is an indicator that analyses past and current price action and verifies trend formation or reversal.
- Leading vs Lagging indicators – which is better?
Both are important and best used in combination. Leading indicators generate trading signals while lagging indicators validate the trade setups.
** Disclaimer – While due research has been undertaken to compile the above content, it remains an informational and educational piece only. None of the content provided constitutes any form of investment advice.