Leading vs. Lagging Indicators
We’ve covered a lot of tools that can help you analyze charts and identify trends. In fact, you may now have too much information to use effectively.
In this lesson, we’re going to look at streamlining your use of these chart indicators. We want you to fully understand the strengths and weaknesses of each tool, so you’ll be able to determine which ones work for you and your trading plan…and which ones don’t.
Leading versus Lagging Indicators
Let’s discuss some concepts first. There are two types of indicators: leading and lagging.
A leading indicator gives a buy 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, you’re missing the boat.”
You’re probably thinking, “Ooooh, I’m going to get rich with leading indicators!” since you would be able to profit from a new trend right at the start. You’re right – you would “catch” the entire trend every single time, IF the leading indicator was correct every single time. But it’s not.
When you use leading indicators, you will experience a lot of fake-outs. Leading indicators are notorious for giving bogus signals which will “mislead” you. Get it? Leading indicators that "mislead" you? Ha-ha. 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. Often the biggest gains of a trend occur in the first few bars, so by using a lagging indicator you could potentially miss out on much of the profit. Which sucks.
Oscillators and Trend Following Indicators
For the purpose of this lesson, let’s broadly categorize all of our technical indicators into one of two categories:
- Oscillators
- Trend following or momentum indicators
Oscillators are leading indicators.
Momentum indicators are lagging 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.
Oscillators / Leading Indicators
An oscillator is any object or data that moves back and forth between two points. In other words, it’s an item that is going to always fall somewhere between point A and point B. Think of when you hit the oscillating switch on your electric fan.
Think of our technical indicators as either being “on” or “off”. More specifically, an oscillator will usually signal “buy” or “sell”, with the only exception being instances when the oscillator is not clearly at either end of the buy/sell range.
Does this sound familiar? It should! Stochastics, Parabolic SAR, and the Relative Strength Index (RSI) are all oscillators. Each of these indicators is designed to signal a possible reversal, where the previous trend has run its course and the price is ready to change direction.
Let’s take a look at a few examples.
On the 1-hour chart of USD/EUR below, we have added a Parabolic SAR indicator, as well as an RSI and Stochastic oscillator. As you have already learned, when the Stochastic and RSI begin to leave their “oversold” region that is a buy signal.
Here we get buy signals between the hours 3:00 am EST and 7:00 am EST on 08/24/05. All three of these buy signals occurred within one or two hours of each other, and this would have been a good trade.
We also got a sell signal from all three indicators between the hours of 2:00 am EST and 5:00 am EST on 08/25/05. As you can see, the Stochastic indicator remained in the overbought for a pretty long time - about 20 hours. Usually when an oscillator remains in the overbought or oversold levels for a long period of time, that means there is a strong trend occurring. In this example, since Stochastic stayed overbought, you see there was a strong uptrend present.
Now let’s take a look at the same leading oscillators messing up, just so you know these signals aren’t perfect. Looking at the chart below, you can quickly see that there were a lot of false buy signals popping up. You’ll see how one indicator says to buy, while the other one is still saying sell.
Around 1 am EST on 08/16/05, both RSI and Stochastic gave buy signals, while Parabolic SAR still showed a sell signal. Yes, Parabolic SAR gave a buy signal 3 hours later at 4 am EST, but then Parabolic SAR turned into a sell signal one bar later. If you actually look at the bar with the Parabolic SAR below it, notice how it’s a strong looking red bar with very short shadows. Also, notice how the next bar closed below it. This would not have been a good long trade.
On the last two oversold (buy) signals given by Stochastic, notice how there is no indicator at all for RSI, but Parabolic SAR is giving sell signals. What’s going on here? They are each giving you different signals!
What happened to such a good set of indicators?
The answer lies in the method of calculation for each one. Stochastic is based on the high-to-low range of the time period (in this case, it’s hourly), yet doesn’t account for changes from one hour to the next. The Relative Strength Index (RSI) uses change from one closing price to the next. And Parabolic SAR has its own unique calculations that can further cause conflict.
That’s the nature of oscillators – they assume that a particular chart pattern always results in the same reversal. Of course, that’s hogwash.
While being aware of why a leading indicator may be in error, there’s no way to avoid them. If you’re getting mixed signals, you’re better off doing nothing than taking a ‘best guess’. If a chart doesn’t meet all your criteria, don’t force the trade! Move on to the next one that does meet your criteria.
Momentum / Lagging Indicators
So how do we spot a trend? The indicators that can do so have already been identified as MACD and moving averages. These indicators will spot trends once they have been established, at the expense of delayed entry. The bright side is that there’s less chance of being wrong.
On this 1-hour chart of EUR/USD, there was a bullish crossover for MACD at 3:00 am EST on 08/03/05 and the 10 period EMA crossed over the 20 period EMA at 5:00 am. These two signals were all accurate, but if you waited for both indicators to give you a bull signal, you would have missed out on the big move. If you calculate from the start of the uptrend at 10:00 pm EST on 08/02/05 to the close of the candle at 5:00 am EST on 08/03/05, you would have watched a gain of 159 pips while sitting on the sidelines.
Let’s take a look at the same chart so you can see how these crossover signals can sometimes give false signals. We like to call them “fake-outs”. Look at how there was a bearish MACD crossover after the uptrend we just discussed.
Ten hours later, the 20 EMA crossed below the 10 EMA giving a “sell” signal. As you can see, the price didn’t drop but stayed pretty much sideways, then continued its uptrend. By the time both indicators were in agreement, you would’ve entered a short trade at the bottom and set yourself up for a loss. Bummer, dude!
Summary
The Million Dollar Question
How do you figure out whether to freakin’ use oscillators, or trend following indicators, or both? After all, we know they don’t always work in tandem.
This is probably the most challenging part about technical analysis. And why I call it the million dollar question.
We will provide the million dollar answer in a future lesson.
For now, just know that once you're able to identify the type of market you are trading in, you will then know which indicators will give accurate signals, and which ones are worthless at that time.
This is no piece of cake. But it's a skill you will slowly improve upon as your experience grows.
Summary
- There are two types of indicators: leading and lagging.
- A leading indicator gives a buy signal before the new trend or reversal occurs.
- A lagging indicator gives a signal after the trend has started
- Technical indicators into one of two categories: Oscillators and trend following or momentum indicators.
- Oscillators are leading indicators.
- Momentum indicators are lagging indicators.
- If you're able to identify the type of market you are trading in, you will then know which indicators will give accurate signals, and which ones are worthless at that time.
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