Understanding leading and lagging technical indicators

As a trader, you may be interested in learning more about lagging and leading indicators and how they work. To properly understand how these indicators differ, we need to begin unpacking technical analysis, patterns and charts. We discuss the best leading and lagging indicators.

Conducting a technical analysis is one avenue to identify whether you’re investing at an opportune time. “Is the financial instrument priced too high? Will it drop lower?” are questions you need to ask yourself whilst trading. There are many technical indicators that try to capture how the market is trending despite all the noise that comes from economic releases, monetary policy decisions, political events, natural disasters and war.

Due to the complexities of trading, technical indicators are displayed on many different types of charts. The most common types of charts are bar, line, point and figure and candlestick charts.

Trading online requires calculated risks, and an effective technical analysis offers the best way of doing so. There are many different technical analysis strategies and most of them can be categorized as either a leading or lagging indicator. So, leading vs lagging indicators, how do they differ?

Using past price data, leading indicators aim to forecast future price movements – allowing traders to enter markets before they rise or fall. If you get this right, there is a good probability that you'll be heading in a direction in your favour.

Lagging indicators influence a more conservative (but safer) approach. Rather than entering a market before a change in price, traders wait for the move before trading.

Leading indicators attempt to identify patterns that repeat with a great deal of regularity. When such a pattern is revealed, the probability of it happening again increases.

Support and resistance levels represent where the market price is at its peak or bottom. There are various methods of measuring these levels, with stop-loss orders and Fibonacci retracement being the two popular approaches.

So, why is it an important indicator? Resistance levels are points where prices have repeatedly pulled back, and support levels are where it has bottomed out. If the market price continues to rise above resistance, it showcases that the asset has upward momentum and could break out from the body. Prices that are continuously bottoming support indicate the opposite.

Conducting pattern recognition is the process of identifying patterns and regularities within a chart. There are three primary patterns to understand when identifying patterns.

1. Ascending/descending triangles: An ascending triangle forms when a flat resistance line connects recent highs and a rising diagonal line connects higher lows; conversely, a descending triangle forms when a flat support line connects recent lows and a falling diagonal line connects lower highs.
2. Triple and double tops and bottoms: This is the pattern of a price consecutively bouncing off the support and resistant levels. Usually, double or triple patterns indicate that the price will move in the opposite direction. For example, if the price ricochets down to up, rather than up to down, it believes the prices will rise.
3. Head and shoulders: It requires identifying three different peaks; two smaller peaks (referred to as shoulders), and a much larger middle peak (known as the head). The methodology behind this pattern is that when all three peaks point upward, the price may fall when it breaks below the neckline - the key support level connecting the pattern’s lows . Whereas, when they point downwards, the price may rise when it breaks above the neckline - the key resistance level connecting the pattern’s highs.

Through identifying intermediate cycles, the hypothesis of Elliot Wave theory is that market prices unfold in specific patterns. The two modes of wave development are motive and corrective. 

A complete cycle contains eight waves, starting with a five-wave motive phase, followed by a three-wave corrective phase. This requires in-depth analysis and should be carried out by experienced traders. As a beginner, focus on other indicators with the aim of eventually identifying cycles within the market.

Lagging indicators focus on trend, sentiment, flow-of-funds and market structure indicators. The majority of analyzing tools are lagging indicators as they are based on price trends, and only provide an indication when the market makes a move.

Great for beginners and used by professionals, moving averages is the process of dividing the number of data points over a chosen period by the total of each data point.

Analyzing moving averages during long-term bull or bear runs introduces clearer confirmations of where the market is going.

A stochastic oscillator helps to identify oversold and overbought conditions by tracking where the closing price finishes. In an uptrend, the closing price typically finishes near the highs. If the closing price is unable to stay near the high or low, it suggests that momentum is slowing. Stochastics perform better in rangebound markets, which makes it less effective in strong trending markets.

Similar to the stochastic oscillator, a Relative Strength Index (RSI) focuses on buying behavior by measuring the price movement of a market. With an index between zero and 100, above 70 indicates the asset has been overbought, below 30 suggests oversold and in between indicates a potentially good time to enter the market.