Lagging indicators use past price data to provide entry and exit signals, while leading indicators provide traders with an indication of future price movements, while also using past price data. When faced with the dilemma of leading vs lagging indicators, which should traders choose? The answer to this question ultimately comes down to individual preference after understanding the advantages and limitations of each.
WHAT’S THE DIFFERENCE BETWEEN LAGGING AND LEADING INDICATORS?
Lagging indicators are tools used by traders to analyse the market using an average of previous price action data. Lagging indicators, as the name implies, lag the market. This entails that traders can witness a move before the indicator confirms it – meaning that the trader could lose out on a number of pips at the start of the move. Many consider this as a necessary cost in order to confirm see if the move gathers momentum. Others view this as a lost opportunity as traders forgo getting into a trade at the very start of a move.
Common lagging indicators include:
- Moving Average Convergence Divergence (MACD)
- Simple Moving Averages (SMA)
- Stochastic Oscillator
- Relative Strength Index (RSI)
A leading indicator is a technical indicator that uses past price data to forecast future price movements in the market. Leading indicators allow traders to anticipate future price movements and therefore, traders are able to enter trades potentially at the start of the move. The downside to leading indicators is that traders are anticipating a move before it actually happens and the market could move in the opposite direction. As a result, it isn’t uncommon to witness false breakouts, or, signs of a trend reversal that just land up being minor retracements.
Common leading indicators include:
- Fibonacci retracements
- Donchian channels
- Support and resistance levels
- Client Sentiment (IG Client Sentiment)
Leading vs lagging indicators: Advantages and limitations
The following table presents the advantages and limitations of each indicator to assist with the ‘leading vs lagging’ conundrum.
|LEADING INDICATORS||LAGGING INDICATORS|
|Advantages||Provide favourable entry points for a possible move.||Provides greater conviction to enter trades – confirms recent price action|
|Leading indicators assist traders in their pursuit of entering higher probability trades because they identify key levels||Reduces the risk of failed moves or false breakouts|
|Limitations||Forecasted price action is not guaranteed. Traders need to apply their own knowledge of these indicators in each situation||Traders sacrifice potential pips while waiting for confirmation from the lagging indicator|
|Leading indicators are often more insightful in advanced technical analysis techniques, such as Elliott Wave Theory, which may be daunting for new traders||Lagging indicators have no concept of key levels therefore, traders need to be aware of this|
SHOULD YOU USE LEADING OR LAGGING INDICATORS?
There are no perfect indicators. By their very nature, indicators will help traders discover likely outcomes as opposed to a sure thing. It is up to the trader to conduct thorough analysis, with the aim of stacking the odds in their favour.
To further illustrate this point, below is an example of leading vs lagging indicators in EUR/USD, where the leading indicator appears to provide a better signal. Keep in mind that this is purely for demonstration and that the lagging indicator is equally as important.
The market sold off aggressively before retracing to the significant 61.8% level. Using a simple moving average (21, 55, 200), it is clear to see that the faster blue line (21) has not crossed below the slower black (55) line and therefore, this lagging indicator has not yet provided a short signal.
However, upon further analysis traders would be able to see that the market failed to break and hold above the 200-day moving average. The 200 SMA is widely viewed as a great indicator of long-term trend and in this example, is acting as resistance. This supports the short bias for traders eying a bounce lower off the 61.8% level.
Traders looking for fast signals will tend to favor leading indicators but can also reduce the time period setting on lagging indicators to make them more responsive. This however, should always be implemented with a tight stop loss to in the event the market moves in the opposite direction.
Traders seeking a greater degree of confidence will tend to favor lagging indicators. These traders often trade over longer time frames looking to capitalize on continuing momentum after entering at a relatively delayed entry level, while implementing sound risk management.
FREQUENTLY ASKED QUESTIONS (FAQS)
If leading indicators provide faster signals on proposed moves then surely, they are superior to lagging indicators?
It is easy to fall into this trap as it is second nature for traders to want to capitalize on a large moves as soon as they appear. Traders need to appreciate that while leading indicators identify possible areas of future price movement, they are not to be viewed as sure things. Further analysis of trend, sentiment and momentum will help to confirm or invalidate the trade.
What combination of moving averages provide the best results?
Once more, this is about personal preference. The most popular moving averages include the 20, 50, 100 and 200 – which can be altered, using Fibonacci numbers to 21, 55, 100 and 200. The 21 period MA can be used in conjunction with the 55 MA for faster, more frequent signals while the 100 and 200 are used to assess market trend.