Leading vs Lagging Indicators for Indian Stocks

Leading and Lagging Indicators

Traders and investors often have dilemmas on leading vs lagging indicators while selecting the most suitable technical indicator. Discussion on leading vs lagging indicators may help us to choose the most appropriate indicators for our trading systems.

Introduction to Leading and Lagging Indicators

Technical analyses of stocks and assets are done with the help of technical indicators. Technical analysis analyses price action and based on such analyses traders and investors make trading/ investing decisions. We find two basic kinds of technical indicators, the leading technical indicators, and the lagging technical indicators.

Leading vs Lagging Indicators
Leading vs Lagging Indicators (Image Courtesy: www.investopedia.com)

Both of these kinds of indicators are used in technical analysis and are often used in everyday trading across the world. Some of these indicators help traders to understand the future path of price action while others help to understand the price trends. Traders across the globe use both of these kinds of indicators to make trading/ investing decisions.

The first kind of indicator is the leading technical indicator. Therefore before we start the comparison of leading vs lagging indicators, let us first know about them.

Leading Technical Indicator

The leading technical indicator is a kind of indicator that helps to predict the future path of a stock or asset’s price. These indicators enable traders and investors to make knowledgeable trading decisions ahead of actual price movement. RSI or Relative Strength Index is a very popular leading technical indicator.

Some very popular leading indicators are Commodity Channel Index or CCI, RSI, and Volume. These indicators are often used in trading and investing. So, we are going to peep deeply into the functions and efficacy of these indicators.

Commodity Channel Index or CCI

CCI - A Leading Indicator
Commodity Channel Index (CCI)

CCI or Commodity Channel Index is a leading technical indicator. Though the name starts with the word commodity, it has no direct relation with commodity trading. Rather this indicator is a very useful indicator for the trading of all assets/ stocks.

The Commodity Channel Index (CCI) is a versatile indicator. Instead, it is an oscillator that oscillates within a band. The band starts with a +100 reading in the upper range. Similarly, the lower band extends beyond -100.

The CCI works as an overbought-oversold indicator. It also acts as a trend detector. As CCI shows the overbought-oversold position of a stock and acts like an oscillator, it is a leading indicator. In addition to this, when the reading goes above +100, the price action is strong and it is in a bullish mode.

Similarly, the stock is said to be in bearish mode if the CCI reading goes below -100. For this property, we also consider it as a ‘Co-incident Indicator’.

CCI is a very popular leading indicator among traders. Traders use it in daily trading, swing trading, or even before making investment decisions. Typical usage of this indicator is in the Woodies CCI trading strategy.

Relative Strength Index (RSI)

RSI or the Relative Strength Index is another highly popular leading technical indicator. RSI is a momentum indicator that shows the overbought-oversold zones of price.

Leading vs Lagging Indicators
Relative Strength Index (RSI) [image courtesy www.investopedia.com]

This indicator shows an oversold condition the RSI reading goes above 70 or 70% as the indicator moves between 0% to 100%. Similarly, when RSI gives a reading below 30 or 30%, it shows the oversold condition of the stock. Traders use RSI as a momentum-based indicator and identify price momentum for entry and exit for trading.

Some traders prefer a reading of above 60 as an indication of positive momentum and use this to enter stock for trading. Contrarily, a reading below 40 is considered negative momentum and used for short trades.

RSI Divergence
RSI Divergence (Negative)

RSI has multipurpose uses. Advance studies and research show different uses of the Relative Strength Indicator. One such use is using divergence between RSI and price.

Divergence occurs when price movement and RSI do not agree in direction. In such cases, the price may follow the RSI direction. We can have positive divergence (bullish) and negative divergence (bearish). In addition to this, traders also use RSI reading during scalping or other types of trading.

Volume

Volume is an important technical indicator. It is generally agreed that delivery with high volume indicates a surge in price. But this condition is not the only factor that controls the price direction.

Volume as a leading technical indicator works best when combined with price movement and other indicators. The following price graph shows how volume as a leading technical indicator works best. A rookie trader must learn to read the volume metrics and how it influences price action.

Leading vs Lagging Indicators
Volume

Volume indicates the number of a particular financial asset traded over a specific period. Usually, the daily volume in a price chart is indicative of traders’ interest in a particular type of specific financial asset. If there is some good news for the stock, the traders may want to accumulate the stock to take advantage. A sudden spike in volume indicates traders’ interest.

A trader may compare the volume of a stock on a particular day with the average daily volume of the same stock in the last year. That comparison helps the trader to reach the conclusion of whether traders have become more interested in the stock recently. Delivery volume matters in such cases.

Interpretation of the Price-Volume Relationship

Contrarily, a divergence in volume with price action may indicate a change in future price direction. If volume decreases and the price goes up, the price may fall soon in the future. The opposite movement happens if the price does not go up significantly but a considerably high volume occurs. This is indicative of a high amount of accumulation which will later lead to a sudden jump in price.

In short, we can summarise the price-volume relation in the following way.

Price increasing – Volume Increasing –> Indication Bullish Price decreasing – Volume Increasing –> Indication Bearish Price increasing – Volume decreasing –> Indication Bearish Price decreasing – Volume decreasing –> Indication Bullish

There are many other leading technical indicators. All these technical indicators help us to forecast or project the future path of price action. But, we must also keep in mind that the future price project obtained through analysis of leading indicators may not always hold. Therefore, we need to be aware and not blindly bank on technical analysis.

Lagging Technical Indicator

The lagging technical indicator is a kind of indicator that follows the path of the price curve of a stock or asset’s price and creates specific patterns. These indicators enable traders and investors to make knowledgeable trading decisions. The Moving Average Indicator is a very popular lagging technical indicator.

In short, these indicators are also known as trend-following indicators. The most popular lagging technical indicators are MA or EMA ( moving average or exponential moving average) and Moving average crossovers, MACD (moving average convergence divergence), and Bollinger Bands. These indicators are often used in trading and investing. So, we are going to peep deeply into the functions and know how effective they are in real trading situations.

Moving Average

The moving average is a very basic indicator yet very popular. The moving average is known as MA in short. It is one of the oldest technical indicators. It calculates the average closing price of a period. MA has many types. We are going to discuss two of the most popular types of moving averages below.

Simple Moving Average (SMA)

The Simple Moving Average (MA) is also known as MA. When the moving average shows the moving average of prices over every day, we call it the Daily Moving Average (DMA). MA is nothing but the average price of the stock or asset over a specific time. DMA is the daily moving average. The MA calculation counts the closing price of a stock over a specified period. The average price is of 14 periods as a standard. But we can customize it.

As a standard, we consider a 50 periods MA, 100 periods MA, and 200 periods MA. But traders also use 5 periods MA, 9 periods MA, 21 periods MA and such. Traders chose whichever suits their trading style or trading system. The chart plots the MA line on the price chart. The trader compares the recent price with the MA line to make trading decisions.

The following chart shows 50 SMA on a price chart. The chart shows that the price is in an uptrend when it goes over the SMA line and vice versa. Thus this lagging indicator helps us to understand the price trend.

Moving Average - A Lagging Indicator
Moving Average(MA)
Exponential Moving Average (EMA)

EMA is the exponential moving average, which is very similar to MA. Only in the calculation of EMA, greater weightage is given to the most recent prices. Thus the Exponential Moving Average reflects the current trend better than the conventional MA. EMA is the modification of MA. Traders may prefer either EMA or MA. Both of them similarly help traders. EMA also shows the trend.

EMA
Exponential Moving Average (EMA)
Moving Average Crossovers

This is not an independent indicator. We consider two or more MAs or EMAs to compare the latest price trend. Traders consider 9 EMA and 50 EMA to get the latest trend. We sometimes take the crossover point of these two MAs to take buy or sell trades. The trading decision lies on traders.

EMA Crossover
EMA Crossover

Moving Average Convergence Divergence (MACD)

MACD - A Lagging Indicator
Moving Average Convergence Divergence (MACD)

The Moving Average Convergence Divergence or MACD is a lagging indicator that uses MA to show the immediate trend. It helps the trader to take trading decisions. MACD shows momentum and trend strength which helps traders to take decisions. It uses two EMAs to plot fast and slow lines. MACD also provides a histogram to give a better view of trend duration.

Bolinger Bands (BB)

Bolinger Bands, also known as BB, is another lagging indicator. BB uses 2 standard deviation values from the mean to produce the upper and lower bands. The middle line shows the mean value. As the price has a common tendency to return to its mean value, the BB creates a band using +/-2 standard deviations to plot the two bands and create a channel. Traders use BB reference lines to create buy/ sell trades.

Bollinger Bands
Bolinger Bands (BB)

In the chart above, we can see that the price curve tends to move away whenever the price highs stay near any of the upper or lower bands. Traders use this tendency of price to create buy or sell trades.

Bolinger Bands is a popular technical indicator. Though it is a lagging indicator, traders use this indicator. Especially for the swing traders or investors who use technical analysis, this indicator shows trades with good accuracy.

Stock prices rarely go to 3 standard deviation prices from the mean. Therefore, the traders commonly use 2 standard deviations for BB. This technical indicator works better in a longer time frame.

In this discussion on leading vs lagging indicators, we can see that both types of indicators are effective. Traders use the leading indicators during intraday trading mostly because these indicators forecast the future price trend.

Traders who use longer time frames prefer lagging indicators. But many traders prefer a trading system that uses both types of technical indicators.

Comparing Leading vs Lagging Indicators in Making Trading Decisions

Leading indicators forecast the direction of price. But the forecast does not always hold because the stock market is unpredictable. Thus leading indicators are not of much help when we take investment decisions.

Contrarily, lagging indicators give us much information regarding short and long time trends. While taking investment decisions, the investor must know about the price trend among other things before investing money into the stock. Therefore, investors tend to take the help of lagging indicators.

Key Differences Between the Two Types of Indicators

Both leading and lagging indicators provide advantages to traders and investors. They have some differences as well. Let’s have a look at the five differences closely.

  1. By definitions, leading indicators forecast the price path in advance whereas lagging indicators follow the curve of the price.
  2. Leading indicators tend to give more false signals compared to lagging indicators.
  3. Leading indicators allow traders to catch the move early and make handsome profits. But the lagging indicators give late signals which make the traders book small profits.
  4. The accuracy of leading indicators is always in question because they provide signals in advance. But lagging indicators provide more accurate signals because they give late signals.
  5. Intraday and short-time traders and scalpers tend to use leading indicators. Swing traders, long-term traders, and investors tend to bank on lagging indicators.

It is always better to use a combination of indicators to get accurate trading signals. One should not use a single indicator in trading to avoid false signals.

Leading vs Lagging Indicators – Which is Better?

Leading and lagging indicators are different types of indicators. It is hard to find the better type. Leading indicators are best for short-term trading while lagging indicators suit best long-term traders and investors.

But the combination of the two types in one treading system gives the best results. When these town types are used simultaneously, the drawbacks of each system are nullified somewhat. Such combinations give the best results.

Importance of Using Multiple Indicators

Many traders and professionals use their trading systems. Most of these trading systems consist of a combination of leading and lagging indicators. The advantage of using multiple indicators is that the system tends to produce more accurate results. All indicators have their inherent drawbacks. When a combination of these is used, a better system develops that produce accurate buy/ sell calls.

Using Multiple Leading and Lagging Indicators
Trading System with multiple indicators

In the chart above, the trading system consists of BB, VWAP, CCI, and Volume. CCI and Volume are leading indicators whereas VWAP and BB are lagging indicators.

trading signals from multiple indicators

A trade may buy when CCI>100, the price is above VWAP and the price is going away from the lower band. Similarly sell signal occurs when CCI<100, the price is going away from the upper band and is below VWAP. Such systems provide accurate trading signals.

Common Mistakes to Avoid When Using Multiple Indicators

Rookie traders tend to jump to decisions whenever an indicator gives trading signals. This tendency must be avoided. No indicator alone is good enough to provide truly accurate trading signals always.

Tips for Rookie Traders
  • It is advisable to use multiple indicators, preferably a combination of leading and lagging indicators to produce good and accurate signals.
  • Trade only when all indicators give the same signals.
  • Do not jump for a trading call unless the situation is acceptable. It is never too late for trading.

FAQ

What is the difference between a leading and lagging indicator?

Leading indicators forecast price action while lagging indicators follow price action. Leading indicators are best for short-term trading like intraday. Lagging indicators are best for swing trading and investing.

What are examples of leading and lagging indicators?

Leading indicators are Commodity Channel Index (CCI), Relative Strength Index (RSI), Volume, etc. Lagging indicators are Moving averages, Bolinger Bands, Moving Average Convergence Divergence (MACD), etc.

What are three examples of leading indicators?

Commodity Channel Index (CCI), Volume, and Relative Strength Index (RSI) are the most popular leading indicators. Other leading indicators are the Ichimoku Cloud, Awesome Oscillator, Pivot Point, Fibonacci Retracement, and OBV or On Balance Volume.

What is a lagging indicator example?

The lagging indicator is Bolinger Bands. There are many other lagging indicators are there. All trend indicators are lagging indicators. Also, all moving average indicators are also lagging indicators.

Leading vs Lagging Indicators – Summing Up

In this article, we have seen how effective the leading and lagging indicators are. We have shown their effectiveness in charts and how these indicators generate trading signals in charts.

We have also discussed the differences between leading and lagging indicators. In addition, we also discussed when they are more effective than other times.

To sum up, we must say that both types of indicators have their inherent advantages. Traders and investors in the Indian stock market frequently use these indicators during technical analysis.

To conclude, a trading system always works better when a combination of leading and lagging indicators are used simultaneously. We should refrain from using only one type or one indicator for trades. All these indicators work well in different time frames and for all types of financial assets available in the Indian stock market today.

References

  • Websites: www. investopedia.com, www. wikipedia.com
  • Books: Technical Analysis of Financial Markets by John J. Murphy, The Art and Science of Technical Analysis by Adam Grimes, A to Z of Technical Analysis by Steven Achelis
  • Videos: Youtube
  • Podcasts
  • Charts: TradingView

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Author: Partha Dhar

Partha is a market analyst, FNO analyst, mutual fund advisor, blogger and a full-time trader since 2005. He also teaches market analysis online

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