There are two types of indicator: leading and lagging.
The leading indicator is the one that nudges the investor to look up at their screens, because something might be about to happen.
The lagging indicator, on the other hand, tells us that something has already happened.
It’s easy to see why traders would be drawn to leading indicators, which can give us a heads-up, and get us into trades nice and early. However, both types of indicators are prone to false signals – with leading indicators giving signals to events that just don’t happen, and lagging indicators telling us too late, when the market has already changed direction.
Let’s look at them more closely to see how they are different, how they’re similar … and how we can get the best of both.
Lagging indicators follow the price. They tell us that the market has moved. You could be forgiven for wondering why you’d want to know what’s already happened … but the past is crucial in helping us plan for the future.
An example of a lagging indicator is a moving average.
When the moving average changes direction, or when two moving averages crossover, it tells us that the price has changed direction.
This gives us the chance to get into a trend and potentially make some money.
But the problem is that the change has already happened (a few candlesticks ago) and it’s very possible that the move is over by the time we’ve got our signal. Try to get into the trend now and you may find the price has turned again, and you’re into a losing trade.
Not at all.
It’s about using them correctly. Lagging indicators can make perfectly good trade signals as long as you accept that they will often miss the move.
A good lagging indicator strategy will be about catching longer term trends. This means that multiple false signals need to be cut short, while those occasional lovely long trends are allowed to run and run.
In the chart above, we can see two losing trades, followed by one winning one. Provided we have an exit strategy that cuts the losing trades quickly, but lets the winning trade run for extended profits – this type of trading can work. It will often involve a low success rate for trades, and the use of trailing stops.
As ever, it’s more about successful trade management than about overly complex signals.
To anyone who’s missed the move on a slow lagging indicator, a leading indicator may seem like the perfect solution.
These are technical indicators that claim to have predictive powers about the way prices are going to act.
They take the form of tools like candlestick patterns, momentum oscillators and volume measures. And they’re looking for signs of market sentiment changing, that a trend could be running out of steam, for example, or about to have an explosive breakout, so traders can take pre-emptive action.
The problem is that – while lagging indicators fail when they miss the action – leading indicators make predictions that never happen.
The chart below shows buy and sell trades triggered by a Stochastic indicator …
While it would be possible to get a profit out of some of these signals, it would be tough to build a successful strategy with this kind of of sensitive ‘trigger happy’ signal.
We can use leading indicators as signals, but (just as with lagging indicators) we should be incredibly careful with risk management to offset the losing trades caused by false signals.
So, if both leading and lagging indicators will let us down …
Let’s see what we DO have …
By combining these two pieces of information, we can create something considerably more powerful than its parts.
The first piece of advice I can offer is to forget about the idea that we’re going to get into a trend at the beginning. Trying to make that kind of call is too tricky and just too unreliable to risk our money on.
So, if we’re looking for an established trend, then we don’t need to fret about the fact that a lagging indicator is delayed – because we’re not looking for an early entry.
What we DO want is reassurance that this trend isn’t about to turn again.
Cue … the leading indicator to give us reassurance that there’s momentum/volume/market sentiment behind the move.
And there we have the recipe for a successful signal …
On the chart below, we get the trend signalled by the moving average crossover, but we aren’t rushing to get into this trend (we know we’re late to this party already, so we’ll only enter if we’re confident it’ll run). When the Stochastic reading moves into oversold territory, and then starts to climb back up – that’s our trigger to buy …
And let’s not lose sight of the fact that – lagging or leading – these tools are all looking at what’s happened, and using that information to give guidance about the future. Past price behaviour is fundamental to both types of indicator. That’s what chart analysis is all about.
Of course, there’s no ‘perfect’ signal – they’re all fallible. Which is why we also need some good trade management to cut losses when we get it wrong, and to maximize profits when we get it right. Intelligent trailing stops are a great tool for this – you can find much more information on how to employ these HERE.
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