Leading indicators are not always better than lagging indicators and vice versa. Why is that so? How to determine which type of indicator is the best one for you?
As a forex trader, you must be familiar with the term 'indicator', especially a technical indicator attached to the price chart. A technical indicator is a technical tool made based on a calculation of the price movement from a currency pair. The main function of the indicator is to help to map the current market condition and predict the price movement based on the established chart. Commonly, traders apply indicators to get trading signals, monitor the direction of the market trends, and confirm signals to open a trade.
Broadly speaking, the types of indicators are only divided into two types: leading and lagging. Leading indicators are identified by their leading movements that precede the price. Stochastic, Relative Strength Index (RSI), and other Oscillators are some examples of leading indicators to a certain extent, as well as some parts of the Ichimoku indicator. On the other hand, lagging indicators tend to move slower than the price. Moving Average and Bollinger Bands are prominent indicators that come from this category.
In the implementation, leading indicators are expected to "lead" traders before making decisions. The advantage of a leading indicator is that it can confirm the price movement from only 1 candle, so it will be very helpful in making entry decisions quickly. Trading using a leading indicator is actually quite risky.
The leading indicators can indeed provide faster entry signals, but it is also very possible that the signal they point is a false one. In this condition, the skills and experience of each trader are one of the important keys to avoiding mishaps. Moreover, various tips on filtering false signals can be applied as additional references.
Leading indicators are generally included in the Oscillator group, which is a type of technical indicator that can show the Overbought and Oversold conditions. If you want to trade using signals from the leading indicators, Stochastic and RSI are two of the most recommended Oscillators for beginners.
Stochastic was first created by George C. Lane in the late 1950s. As an Oscillator, Stochastic can show when the price movements have reached the Overbought and Oversold levels. This indicator has been used by traders, investors, analysts, and market experts for more than 50 years.
Stochastic consists of two lines, namely the %D and %K lines. Both lines are later useful to identify the current trend behavior, based on the distance between the %D and %K lines. If the distance between the %D and %K lines widens, there is a tendency that the trend is getting stronger. Meanwhile, if %D and %K tighten, we can assume that the trend is starting to get weaker. The weakening of a trend can be a starting point for a trend reversal; an opportunity to enter the market with great profitability.
As for the Overbought and Oversold conditions, Stochastic has two extreme points at 20 and 80 to indicate them. Overbought happens when the Stochastic lines break the 80 level, whereas Oversold condition is confirmed when Stochastic lines move below the 20 level.
Relative Strength Index (RSI)
Relative Strength Index (RSI) was first introduced by J. Welles Wilder in 1978 in his book called "New Concepts in Technical Trading Systems". Since then, the RSI indicator has been known as a popular Oscillator and is considered reliable by many. Plus, this indicator is widely used in almost all types of markets, including the forex market.
RSI is useful as an indicator of Overbought and Oversold just like Stochastic. The difference is, this indicator only consists of one RSI line. Besides, Overbought and Oversold levels can be adjusted based on the traders' desire. If Stochastic's levels are normally set at 20-80, the RSI's levels can be pegged at 30-70 or 20-80.
In using the RSI, take note that the entry of the line into the Oversold area indicates a weakening of a Downtrend. Meanwhile, if the RSI line breaks the Overbought limit, it could be a signal of a weakening Uptrend.
How can the RSI show entry positions? If you want to enter a SELL position, then the position of the RSI indicator line must be at the Overbought level first, then wait until the line drops below the Overbought level. Conversely, if you want to enter a BUY position, make sure that the RSI line crosses the Oversold level, then wait for the line to rise again above the Oversold area.
In contrast with leading indicators, lagging indicators tend to be slower in providing entry signals because their nature is to follow and respond to the price instead of creating predictions. Traders may miss opportunities to harvest maximum profits using this type of indicator.
Usually, lagging indicators are often found in indicators that measure a trend direction, so this indicator is also known as "trend-following indicators". Despite their lagging disposition, you can still take advantage of lagging indicators to identify trading signals.
They help traders when the price is trending, hence their popularity among trend followers. In fact, lagging indicators can tell when the price is about to turn back to its major trend so traders can join in the trend and make some profits from it. Here are some well-known lagging indicators that also serve as trend-following indicators:
See Also: Trade By Following Or Against The Trend?
Moving Average (MA)
Moving Average can be mentioned as a simple and easy to use indicator, making it widely used by novice traders. Besides its simple appearance, Moving Average comes with a lot of information that can be used as trading signals.
As a trend direction indicator, MA can indicate the Uptrend and Downtrend conditions based on the price position against the MA line. If the price is above the MA line, then the market is in an Uptrend. On the other happen, if the price is below the MA line, it can be said that the Downtrend is in control.
Furthermore, MA can be used to find opportunities from a crossing between the lines. By using two or more MA lines with different periods, traders can watch for crossing signals as their confirmator before entering the market.
The example of finding an entry position based on the crossing between 5 MA and 20 MA can be seen on the following chart:
Based on the chart above, here are the BUY and SELL rules:
- Buy when the small period MA cuts the big period MA from below.
- Sell when The small period MA crosses the big period MA from above.
Bollinger Bands (BB)
Since it was first introduced by John A. Bollinger in 1980, the Bollinger Bands has become one of the most popular trading indicators, especially during the trending conditions. A strong uptrend can be seen if the price has broken through the Upper Band and is closed outside the band. Conversely, a trend can be said to be a downtrend if the price breaks the Lower Band and closes outside the band as well. For a more obvious picture, here is an example of trading with the Bollinger Bands:
Based on the chart above, it can be said that a BUY position is in order when the price breaks the Upper Band and closes outside the band. The widening of the bands following the position confirms the strength of the Uptrend, making it a profitable choice for traders who use the BUY signal from the beginning.
Moving Average Convergence Divergence (MACD)
MACD (Moving Average Convergence Divergence) indicator is very popular and widely used by traders in the forex market. This technical indicator was created by Gerald Appeal in 1979. It did not take a long time until MACD received great acceptance from various market players because of its simplicity and flexibility.
The indicator consists of two EMA lines (12 EMA and 26 EMA) as well as a histogram that transitions between a positive and a negative zone. the MACD indicator can be used to confirm the trend direction and find entry signals. The trend direction and strength can be defined from the histogram position, while the entry signals can be taken from the crossing between the two EMA lines.
In short, here are the rules of trading with a MACD indicator:
- 12 EMA is above 26 EMA and the histogram is positive = Uptrend.
- 12 EMA is below 26 EMA and the histogram is negative = Downtrend.
- BUY if the histogram is in the positive area, and 12 EMA crosses 26 EMA from below.
- SELL when the histogram is in the negative area, and 12 EMA crosses 26 EMA from above.
See Also: A Trader’s Guide to EMA Strategy
Leading Vs Lagging Indicators, Which is the Better One?
Lagging indicators are important because it provides information as far as the ongoing price, how long the period has been run, and what levels have been reached. Yet, the use of leading indicators is just as crucial, especially to generate trading opportunities that don't fall too far behind from the current price movement. It would be better if the use of the two trading indicators can be balanced and adapted to the market conditions.
If the market is trending, then a lagging indicator is more suitable. This is because lagging indicators mainly consist of trend direction indicators, such as Moving Average, Bollinger Bands, or MACD. Meanwhile, a leading indicator should be used if the market is sideways because it can indicate Oversold or Overbought conditions.
What types of technical indicators are the best? If it is your question, then the answer relatively depends on the strategy, the trading style, and the level of understanding. In addition, it needs to be realized that every indicator has its own advantages and disadvantages, and the performance may depend on the user.
For those of you who want to build your own trading system but still confused when it comes to picking the most suitable indicator, perhaps some of the criteria below can be taken into consideration:
Easy to Understand
The characteristic of a good indicator is that it is easy to understand. Nevertheless, everyone's perspective on "easy to understand" may be different, depending on their level of understanding. So, the first step you can take is to choose the indicator that you think is the easiest and not confusing.
As a matter of fact, technical indicators are limitless and it is impossible to master all of them. Therefore, make sure that your chosen technical indicators can help you in reading the signals in a simple manner. On the other hand, if you feel that the indicators cause more confusion and are hard to understand, there are two possibilities to consider: Your understanding of the indicators is lacking, or the technical indicators are not suitable for your trading style, resulting in frequent errors in making decisions. In that case, you should not force yourself to use those indicators.
Next, the characteristic of a good indicator relates to the signal reading and its application in trading. Sometimes, some indicators are understandable and based on mathematical calculations that are easy to comprehend. Unfortunately, not all of them are also easy to use. Remember, choosing the best indicator in forex trading is not determined by the level of its complexity, but from its ease in helping to find the best signal.
Using complicated indicators is wasting time. You will only focus on understanding the characteristics of the indicators without getting any obvious benefits. Eventually, it will take up a lot of your time. If you think about it again, finding out other indicators that are easier will be much more efficient and useful.
Indicators are Merely Tools, Not the Ultimate Key to Profits
Using forex trading indicators will not determine your trading results. It should be underlined that indicators are just some tools to help you read signals. The analysis of data processing and decision-making is absolutely in the hands of each trader. Loss or profit depends on how reliable a trader is in taking advantage of the right moment to open a position, which is mostly influenced by personal psychological and management skills. It is clear that indicators have little to no contribution to what causes profits and losses in forex trading.
However, you can try to identify the criteria of good indicators to at least increase your trading opportunity. In this case, you can see from two sides. It can be seen from the ease of understanding the indicators, or on the level of complexity of implementing and reading the indicators' signals.
To help you single out technical indicators that are worth to try, we have prepared a good insight into the three most important technical indicators that you should know.