Leading vs. Lagging Indicators – Who is the Clear Winner
Technical indicators form an essential element to day trading and are valuable tools for day traders as well as prop trading firms. In fact, without the use of technical indicators, more than half the automated trading strategies or algorithmic trading would not exist.
While there is always a debate between technical analysis and fundamental analysis and thus by extension, technical and fundamental indicators, the fact remains that in the very short term, such as day trading, technical analysis calls the shots.
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Technical analysis is all about forecasting price by analyzing the past price history. Over the years, the field of mathematics and physics to some extent has found its use in developing various technical indicators.
Today, one can find technical indicators from the very simple such as moving averages to the more complex technical indicators such as Elliott wave counting, as an example.
No matter how simple or complex a technical indicator is, most often these indicators can be categorized into two classes; leading or lagging technical indicators.
What is a leading technical indicator?
A leading technical indicator is basically designed to lead the trader into anticipating what price will do next. A leading technical indicator in a way is a forecasting tool in its entirety. Magical as it may sound, a leading technical indicator relies upon the most important variable, which is price.
A leading indicator forecasts based on a number of factors, but most commonly uses momentum or even volume as a means to predict what price will do next.
The chart below shows a few of the candlestick patterns based on the candlestick charts which are probably the best examples of how leading indicators work. The patterns identified in the chart below signal a shift in sentiment.
Of course, despite the simplicity shown in this example, it is always best for the trader to confirm such signals with other indicators as well.
An important aspect to bear in mind with leading technical indicators is that they are not always right as eventually it is price that is the ultimate leading indicator. Look at the above chart and you will find examples where despite a bullish signal given, price behaves otherwise.
Other examples of leading indicators include momentum or volume oscillators. These indicators focus on the principle that momentum or volume starts to change ahead of price itself (lending support from the principles of physics).
Thus, many technicians have developed various technical indicators measuring momentum or volume in an effort to build a robust technical indicator that could signal what price could do in the near future.
Some examples of leading technical indicators include the Relative Strength Index (RSI) or even simply volume, which is more easily recognizable. Volume tends to show changes even before price as it truly represents the ever-changing buying and selling pressures in the market.
Below is a classic example.
You are looking at a 10-minute chart for Microsoft (MSFT) with only volume as the indicator.
If you closely analyze price and volume, you can see that from the area marked 'start' and the subsequent rally in price, volume starts to fall. For someone who viewed the chart without volume would easily mistake price to be in a strong uptrend.
As price peaks out near $66.30 posting a high, you can see that volume is not confirming the bullish momentum led rally, signaling ahead that prices could fall.
Eventually, price makes another attempt at $66.30 and crashes strongly and this time the decline in price is confirmed by strong selling pressure as indicated by the strong volume bars.
What is a lagging technical indicator?
A lagging technical indicator is often said to be smoother and less prone to fake signals. However, as the name suggests, lagging indicators often signal very late into a trend and thus come at a risk of a price reversal.
Still, many traders prefer to use lagging technical indicators as it helps them to trade with more confidence. Usually traders make use of two or more lagging indicators to confirm the price trends before entering the trade.
This can be viewed as a conservative way to trade, but do not let this draw you into a false sense of security that you can make money consistently by being conservative. Despite the obvious advantages of the lagging indicator over the leading indicators, they are by no means fool proof.
A lagging indicator often makes use of price as an input variable and in most cases, requires a longer look back period in order to ascertain trends.
Let’s look at a classic example of a lagging indicator set up which is a 50 period and a 200 period moving average. We know the golden and a death crosses, which are nothing but bullish and bearish crossovers of the 50 and 200 SMA’s.
Generally, the security is said to be bearish when the 50 SMA crosses below the 200 SMA and the security is said to be bullish when the 50 SMA crosses above the 200 SMA.
The following example shows the 50 and 200 SMA applied to the daily chart for QQQ ETF chart.
In the above chart notice the four signals generated by the bullish and the bearish crossovers of the 200 and 50 period moving averages. In the first signal from the left, if one went short on the security after the bearish signal was given, it would have been a losing trade.
This is because by the time price moved lower and the SMA’s reacted to this, price already fell significantly and started to pull back higher.
Likewise in the next example we get a bullish crossover. If a trader were long on this signal, it would once again end up with a loss because we see that price pretty much stalls near the previous highs before falling back lower.
The third bearish signal we see worked somewhat in our favor however as price fell only a few points lower before starting to reverse the trend.
Among the four signals, it was only the last signal that worked as the bullish crossover signal saw a meaningful rally in prices thereafter.
What the above example tells us is that despite being lagging, the lagging indicators are by no means fool proof.
What are the differences between leading and lagging indicators?
As the name suggests, leading and lagging technical indicators are clearly two different sides of the coin. Lagging indicators mostly focus on the output and one can see that lagging indicators are often more smooth in terms of values and even in visual terms.
On the other hand, leading indicators are more sensitive to the values and can often result in choppy markets. Leading indicators can also be easily influenced by short term volatility in the markets.
For a day trader it is all about finding the right combination of technical indicators as both these two types of technical indicators tend to have their own short comings. Furthermore, entirely different set of trading strategies can be easily built depending on the type of indicator one uses.
One of the biggest differences is that leading indicators often forecast what might happen. However, this may or may not come to pass. For example, a leading indicator could suggest that price of the security might fall. Traders will need to seek confirmation from other indicators in order to validate this view.
A lagging indicator on the other hand gives a confirmation of the leading indicator. However some times, depending on the input values of a lagging indicator, it could be too late as price would have already behaved as expected and could be moving on to establishing a new trend for example.
From the above, what we know that there is no clear winner among these two types of technical indicators and in fact the trader will need to focus on both the leading and lagging indicators in order to get a full picture of the market.
For example, what better way to view the markets then to have a leading indicator signal a potential downtrend and to have a lagging indicator validate this view.
Drawbacks of leading and lagging indicators
Both leading and lagging indicators comes with their own set of drawbacks. For starters, leading indicators tend to be very choppy and react to prices quickly. This means that leading indicators are prone to giving false signals making them somewhat unreliable.
On the other hand, lagging indicators are slow to react meaning that whatever price trend a trader wanted to capture would have already completed the strong part of the trend, meaning that there would be significant risks of a pull back or a reversal in price.
Combining leading and lagging technical indicators
While there are certain technical indicators that are considered to be leading indicators, there are some patterns/phenomena as well that are good example of leading indicators. Examples include price action itself, and of course divergence.
Let’s see how a trader can make use of a leading and a lagging indicator to get a better view of the markets. In this following example, we take a look at how one can combine the concept of divergence as a leading indicator and moving averages as a lagging indicator to trade.
The following chart shows a 15-minute time frame where we have a standard Relative Strength Index (RSI) and two exponential moving averages. The settings (inputs) for these indicators are pretty standard, if not randomly selected, to prove the point how leading and lagging indicators can work together.
Here, we first notice a bearish divergence on the chart, identified by price making a higher high while the 14-period RSI makes a lower high. This bearish divergence is a leading indicator and informs the trader of a potential bearish trend that is likely to take place.
Note that with leading indicators, there is a possibility for the signal to be invalidated. Thus, traders who typically would act on the signal from the leading indicator will be at a loss, something which we will cover shortly.
Getting back to the above example, you can see that after the leading indicator (divergence) signaled a bearish trend, this is confirmed by the moving averages bearish cross over.
The moving averages are lagging indicators and when viewed in the context of the bearish trend that was initially pointed out by divergence, the trader is at a better odds of trading this short signal by acting upon the validation of both the leading and lagging indicators.
You can see how powerful, yet simplistic it is when it comes to combining both the leading and lagging indicators.
Is leading or lagging indicator, better to use?
For traders, it is often the dilemma of finding a balance between the leading and lagging indicators. Rely solely upon leading indicators and chances are that you could end up being whipsawed by price and prone to many false signals.
Rely solely on lagging indicators and while there is a chance of making some money, you would most likely end up with just a few bread crumbs, missing out on most of the profits already.
With the drawbacks obvious, it is clear that traders are at better odds of developing a strong trading strategy that focuses on combining both the leading and lagging indicators. When both these indicators tend to confirm one another, the probability that the trade will result in a profit is much higher, thus reducing the risks.
At the end of the day, it is up to a trader on how they want to trade. Certainly there are traders who rely just on leading indicators and others who rely just on lagging indicators and have managed to make a profit consistently.
For day traders it is all about understanding the indicators that are being used and the information that they signify that matters which will help them to become better at analyzing the markets.
Thus, there is no clear winner when it comes to choosing between leading or lagging indicators, but rather a tie!