All you wanted to know about leading and lagging indicators in trading

Technical indicators assist in reading charts which, in turn, facilitate in confirmation of a trend. From the psychological view point, this helps traders develop a feeling of confidence while trading. The deeper knowledge of technical indicators aids in building a trading model that can deliver consistent returns over a period of time. One can then efficiently predict the future outcome of any trading instrument with deeper insights of the technical setup.

Technical indicators are briefly categorized into two spheres: leading and lagging indicators. Leading indicators are those that lead the price movement. On the other hand, lagging indicators always follow the price and are also defined as trend-following indicators.

Both indicators have different use in a trading model. It is not easy to follow the price after a leading indicator delivers a trading signal. The buy/sell signal needs to be consistently observed to acknowledge the price move and any reversal points. Lagging indicators, meanwhile, facilitate profit booking and help reduce the risk of trend reversals.

Leading Indicators

Relative Strength Index (RSI)

Stochastic Oscillator

Fibonacci retracements

Volumes

Lagging Indicators

Moving Average Convergence Divergence (MACD)

Moving Averages

Bollinger Band

Parabolic SAR

Pivot Points

Advantages and limitations of leading and lagging indicators

Both the indicators provide entry points. Leading indicators signal on breakout levels whereas the lagging ones confirm on a sustained basis. However, both cannot guarantee exact returns. Sometimes, one needs to take quick decisions on uncertain trends on the basis of their own knowledge.

 A single leading indicator might not provide the acute trend, unless it is combined with a lagging indicator. Also, lagging indicators have performed well when combined with leading indicators. Meanwhile, few uncertain movements like Gaps and high volatility cannot be purely determined by either leading or lagging indicators.

How to use leading and lagging indicators

The trading signals provided by both kinds of indicators have significant implications. However, when combined, these indicators can together deliver tremendous output. For example, trading models have evolved with several strategies where RSI or Stochastic is combined with moving averages that have benefited market participants.

From a broader perspective, long-term investors majorly prefer lagging indicators as the confirmation is more on a sustained breakout. A lagging indicator might provide a delayed signal, however, it determines fairly accurately the strength and momentum of the trend.

Sometimes, leading indicators may confirm a rally that may not provide an assumed target. This may be due to some uncertain developments in the country's economy. This move can be addressed efficiently by respecting the shift in price movement.

There is no single perfect module to assess the markets. But, understanding the significance of technical indicators in different scales and periods definitely helps in trading behaviour.