Trading indicators can be categorized into leading indicators, lagging indicators, or even both, depending on the type of information they provide and their speed of response to price action. Understanding how they work will help you know the best way and when to use certain market indicators when performing technical analysis. This knowledge can also help you better interpret market events based on the indicators you use.
What are leading and lagging indicators?
Leading and lagging indicators are technical indicators that give crypto traders an idea of what might happen next in the market or what has already happened. Both indicators provide traders with market information to guide their trading decisions. The main difference between the two indicators is the timing of the signal they provide.
The main indicators
Leading indicators are indicators that signal where the price might move next. These indicators use price data to forecast future price movements. Leading indicators can help you catch trends earlier, providing favorable trade entry and exit points. They are often more insightful for technical analysis as they can help you in your quest to enter high probability trades.
Lagging indicators are also called trend following indicators simply because they follow market trends. These indicators only focus on historical data and do not suggest what might happen next in the market. They use the average of previous price data to inform traders of market events.
5 examples of leading and lagging indicators
To better understand how these technical indicators work, consider the following examples.
Leading Indicator: Fibonacci Retracement
Fibonacci retracement levels are horizontal lines used to determine possible support and resistance levels. The indicator can help you determine entry, stop-loss and profit points. The Fibonacci retracement works best in a trending market.
If the price begins to decline or retrace in an uptrend, traders using the Fibonacci retracement tool will draw the retracement line to connect the last relevant swing high and swing low. This would help them see the invisible support levels in the market, which would allow them to easily determine where the price might reverse and where the uptrend would continue.
Leading Indicator: Candlesticks
A candlestick indicates the opening, closing, high and low prices of a market over a given period. Each candlestick contains specific information that it embodies. A trained trader understands the information and uses it to navigate the market. In other words, each candlestick provides an easy-to-understand picture of price action.
You can use the length of the candlestick wicks, the body of the candlestick, and whether it is bearish or bullish to determine what is happening in the market and what might happen. Common candlestick patterns include dojis, engulfing candlesticks, spinning tops, hammerheads, and pinbars.
Lagging Indicator: Moving Averages
Moving averages identify the trend and direction of a crypto market. Moving average information is generated using previous price points, i.e. historical market data.
Moving average lines generate buy and sell signals when they cross, although traders cannot rely on them for the best trade entries. This is because by the time the moving average lines display signals to buy or sell, the price movement must have started some time before, making any response you make to the moving average signal late.
Leading and Lagging Indicator: Bollinger Bands
Bollinger Bands consist of a moving average, serving as the middle band and the upper and lower bands, identifying whether the price is relatively high or low. Traders consider the upper band an overbought position and the lower band an oversold position. Thus, they buy when the market is near or below the lower band and sell when it is near or above the upper band.
Bollinger Bands, like the RSI (see below), are inherently lagging indicators because they move after price moves. They only react to price movement. However, the outer bands can work as leading indicators, as they suggest that the price might reverse.
Leading and Lagging Indicator: Relative Strength Index
The Relative Strength Index (RSI), another inherently lagging indicator, tells crypto traders when a market is overbought or oversold. The RSI fluctuates between 0 and 100, usually calculated over a 14-day period. A scale above 70 is considered overbought and below 30 is oversold. The RSI also gives information about who controls the market. Traders usually take a scale above 50 as the buyers market and below 50 as the sellers market.
The main problem with RSI, just like other lagging indicators, is that signals usually arrive late. The market must have been bullish for a while before it reflected on the RSI chart.
The RSI can also work as a leading indicator, showing traders what might be happening in the market. Consider the case of RSI divergence. The RSI divergence signals that the current trend has lost momentum and there is a possibility of a trend reversal. This could be seen as an early warning sign and would tell traders that a possible reversal is imminent. In the case of an RSI divergence, the RSI shows a change in market momentum before it is reflected in price, thus functioning as a leading indicator.
How to Use Lagging and Leading Indicators
From the categorization above, you see that some crypto technical analysis indicators work as leading indicators, some as lagging indicators, while others are both leading and lagging indicators, depending on how they are interpreted.
Some traders use a combination of leading and lagging indicators when trading. Some traders prefer to use leading indicators only, trading with Fibonacci retracement lines, support and resistance, candlestick languages, and any other leading indicator they find useful. The categorization is primarily functional, as deciding whether to use them depends on your crypto trading strategy.
Now that you know how the leading and lagging indicators work, you can better interpret the chart information in relation to your strategy. For example, trying to enter a buy because there is a moving average crossover showing a buy signal would likely be a late entry. Since the moving average is a lagging indicator, it is not good for determining trade entry and exit points.
On the other hand, lagging indicators are useful when checking historical data and price movement over time. However, nothing prevents you from using the information to predict future market events.
No indicator should be used as a standalone indicator. You need to combine it with other tools to make better trading decisions.
As has been shown
After understanding what leading and lagging indicators are, it is safe to say that both indicators are necessary tools for successful trading. Deciding how to use them depends solely on how your strategy works best. Certainly, we cannot deny that knowing how they work and how to interpret the data they provide will be an advantage for you when carrying out your market analysis.