As much success that traders have had using the methods of technical analysis and indicators to drive their decisions, but the indicators are still viewed as just numbers, the assumptions that were used in the mathematics behind it and the real significance behind those numbers are all still in the dark and people use them without knowing their utility, nuances and most of the pitfalls.
This article is to shed some light on this issue in a more specific context, namely, Leading and Lagging indicators. We will focus on the difference between the two and in what particular contexts they are to be used in and why having half-knowledge in this regard can be seriously punished by the markets.
First of all, it is beneficial to have mental models that will help these concepts stick, as they get more complex. So at the core, what any “indicator” gives us is information. Now this information can either be a Signal (A trading decision, invoking an action) or information that helps us make a trading decision, Support Info. Of course, the nature of the information and its intent (Support or Signal) differ widely. One big differentiator in indicators is whether it gives us the information before or after the underlying event/movement has happened.
These indicators are called Leading indicators - Indicators that give information ahead of time, before a price move like a breakout or mean reversion has happened. These indicators are like warning horns, indicating that something is going to happen. This happens because they are predictive and use past tendencies to predict future tendencies of the data. Some examples of Leading indicators are :
RSI
Stochastic Oscillator
Williams Oscillator
The basic concept of the math behind these indicators is to observe statistical properties of data, their consequences and then extrapolate the same thing in the future. One can immediately see the dangers of this approach. Few basic points that the mind immediately makes in response to this method are :
The future doesn’t necessarily always behave like the past, especially in the markets.
As soon as the word future comes up, the risk of uncertainty is already implied.
So, any trader or investor using a leading indicator needs to keep the following things in mind :
A Leading indicator can only be used as Support Info and never as a Signal, since we already saw that they contain a considerable amount of uncertainty.
Even when used as Support info, the trader must take precautions in terms of risk management of the trade and what exactly to do if the trade goes wrong.
It is very important to know the real meaning behind the indicators and what they imply. For example, RSI is a widely used leading indicator that is generally used to know when a “trend is going to reverse”. It does this by comparing the current price momentum with a previous window of ‘x’ periods and shows how much more/less the instrument has moved in this period as compared to the last ‘x’ periods. The main assumption behind this is that the price will move to a mean value after it reaches the top of the range of the previous period movement. This is considered as ‘overbought’ or ‘oversold’ on the threshold of values 70 and 30 respectively.
Now, it may very well happen that the RSI indicator shows a value like 85 and you think that it is time for shorting. But then the price picks up and you get stopped out, at best. How can this happen even after we know the value of the indicator is in our favor? The truth behind this is that it is also possible that the strong recent movement that the Indicator interpreted as a selling opportunity could have just been a beginning of a new long-term trend than the timeframe of your indicator. This is an example of a scenario where not knowing the nuances of the indicators can get you into problems. Despite all these things, leading indicators make good opportunity spotters for future trades and warning signals for current ones.
The other category of indicators are Lagging Indicators - Indicators that give the information AFTER an event/price movement has occurred. These indicators are more of a decision supports. Information like movement confirmations or rejections.
As the name suggests, these Lag in time and generally give confirmations of movements. They are ideally used in scenarios where you have an idea as to how the market is going to play out and you are waiting for the right time to enter or for confirmation of a move. If you believe that the instrument is going to have a breakout on the long side, then you can look to a lagging indicator as confirmation that the trend is strong and is now confirmed, at which point you can go ahead and place your trade more confidently. Popular examples of Lagging indicators include :
All variants of Moving Averages
MACD
Bollinger Bands
Moving averages are calculated by taking the average of the prices over a defined period in the past and comparing it with the current price. The main idea behind these is also the assumption that the market price usually reverts to the mean value. Decisions are made using these moving averages and their difference from the current price. Even combinations of fast, slow-moving averages and their crossovers are used as Support Info. For example, if you are looking at a possible long breakout setup, you can use moving average crossovers to confirm (mostly) whether that is the case and then you can more confidently place your trade.
Important points to be kept in mind while using Lagging Indicators :
They point towards things/movements that have already happened and thus don’t have any signal-worthy information on their own.
These are to be used where confirmation or rejection of your outlook on the markets helps make a trade.
These can also be useful in helping to figure out proper Exit and Entry levels. (You can get out of a trade if multiple indicators are pointing to the end of a trend or a swing.)
All in all, Indicators are a very good use of math to help support our investment or trading decisions, but their use as sole decision points or as Signals, is asking for failure. It is important to know the nuances, the assumptions, the weak and the strong points of what indicator you are using. Not knowing the logic and concepts or reasons behind indicators is a sure and very painful way to lose your money. But, use them wisely and you have a solid chance of extracting value from the markets even when they might seem like a stone.