Trading indicators can be categorized as leading indicators, lagging indicators, or even both, based on the type of information they give and their response speed in relation to price action. Understanding how they work will help you know the best way and time to use certain indicators in the market during technical analysis. The knowledge can also help you better interpret market happenings 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 could happen next in the market or what has already happened. Both indicators provide traders with information from the market to guide their trading decisions. The major difference between the two indicators is the timing of the signal they provide.
Leading indicators are indicators that signal where the price could move next. These indicators use price data to forecast future price movements. Leading indicators can help you enter trends early, providing favorable trade entry and exit points. They are often more insightful for technical analysis because they can assist you in your pursuit of entering high-probability trades.
Lagging indicators are also known as 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 happenings.
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 to determine trade entry, stop-loss, and take profit points. Fibonacci retracement works best in a trending market.
If the price starts to go down 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. Doing that would help them see the invisible support levels in the market, making it easy to determine where the price could reverse and the uptrend continue.
Leading Indicator: Candlesticks
A candlestick shows a market’s open, close, high, and low prices within a specified period. Each candlestick has specific information it embodies. A trained trader understands the information and uses the information to find his way around the market. Put another way, each candlestick provides an easy-to-understand picture of the price action.
You can use the length of the candlestick wicks, the candlestick body, and whether it is bearish or bullish to determine what is happening in the market and what could happen. The common candlestick patterns include dojis, engulfing candlesticks, spinning tops, hammers, and pin bars.
Lagging Indicator: Moving Averages
Moving averages identify the trend and direction of a crypto market. The information on the moving average is generated using previous price points, i.e., the market’s historical 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 moving average lines show either buy or sell signals, the price movement must have started a while before then, 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 a middle band and an upper and lower band, 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 close to or below the lower band and sell when it is close to or above the upper band.
Bollinger bands, just like RSI (see below), are inherently lagging indicators because they move after the price moves. They only react to price movement. However, the outer bands can work as leading indicators as they suggest when the price could 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 oscillates between 0 and 100, typically calculated over a 14-day period. A scale of over 70 is considered overbought, and below 30 is oversold. The RSI also gives information about who is in control of the market. Traders usually take a scale above 50 as the buyers’ market and one below 50 as the sellers’ market.
The major issue with depending on the RSI, just like other lagging indicators, is that the signals usually come late. The market must have been bullish for a while before it reflects on the RSI chart.
The RSI can also function as a leading indicator, showing traders what could happen in the market. Let’s consider the case of RSI divergence. RSI divergence signals that the current trend has lost momentum, and there is a possibility of a trend reversal. This could be taken as an early warning sign and would reveal to traders that a possible reversal is imminent. In the case of an RSI divergence, the RSI shows a change in the market momentum before it reflects in the price, thus, working 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 only leading indicators, trading with Fibonacci retracement lines, support and resistance, candlestick languages, and whatever leading indicators they find useful. The categorization is mainly functional, as the choice of how you use them depends on your crypto trading strategy.
Now that you know how leading and lagging indicators work, you can interpret chart information better in relation to your strategy. For example, trying to enter a buy because there is a moving average crossing 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 how prices have moved over time. However, nothing stops you from using the information to predict future market happenings.
No indicator should be used as a stand-alone indicator. You must combine it with other tools to make better trading decisions.
As Has Been Shown
Having understood what leading and lagging indicators are, it is safe to say that both indicators are necessary tools for successful trading. The choice of how to use them only depends on how your strategy works best. Surely, we cannot deny that knowing how they work and how to interpret the data they give will be an advantage for you when carrying out your market analysis.