Leading/Predictive vs. Lagging/Trend-Following Indicators
We’ve already covered a lot of tools that can help you analyze potential trending and range-bound trade opportunities.
Still doing great so far? Awesome! Let’s move on.
In this lesson, we’re going to streamline your use of these chart indicators. We want you to fully understand the strengths and weaknesses of each tool, so you’ll be able to determine which ones work for you and which ones don’t.
Let’s discuss some concepts first. There are two types of indicators: leading and lagging.
A leading indicator gives a signal before the new trend or reversal occurs.
A lagging indicator gives a signal after the trend has started and basically informs you “Hey buddy, pay attention, the trend has started and you’re missing the boat.” You’re probably thinking, “Ooooh, I’m going to get rich with leading indicators!” since you would be able to profit from a new trend right at the start.
You would “catch” the entire trend every single time IF the leading indicator was correct every single time. But it won’t be.
When you use leading indicators, you will experience a lot of fakeouts. Leading indicators are notorious for giving bogus signals which could “mislead” you.
Get it? Leading indicators that “mislead” you?
Haha. Man, we’re so funny we even crack ourselves up.
The other option is to use lagging indicators, which aren’t as prone to bogus signals.
Lagging indicators only give signals after the price change is clearly forming a trend. The downside is that you’d be a little late in entering a position. Often the biggest gains of a trend occur in the first few bars, so by using a lagging indicator you could potentially miss out on much of the profit. And that sucks.
It’s kinda like wearing bell-bottoms in the 1980s and thinking you’re so cool and hip with fashion….
It’s kinda like discovering MySpace for the first time when all your friends are already on Facebook…
It’s kinda like getting excited buying a new flip phone that now takes photos when the iPhone XS came out…
For the purpose of this lesson, let’s broadly categorize all of our technical indicators into one of two categories:
- Leading indicators or oscillators
- Lagging or trend-following indicators
While the two can be supportive of each other, they’re more likely to conflict with each other.
We’re not saying that one or the other should be used exclusively, but you must understand the potential pitfalls of each.
How to Use Oscillators to Warn You of the End of a Trend
An oscillator is any object or data that moves back and forth between two points.
In other words, it’s an item that is going to always fall somewhere between point A and point B.
Think of when you hit the oscillating switch on your electric fan.
Think of our technical indicators as either being “on” or “off”. More specifically, an oscillator will usually signal “buy” or “sell” with the only exception being instances when the oscillator is not clearly at either end of the buy/sell range.
Does this sound familiar? It should!
The Stochastic, Parabolic SAR, and Relative Strength Index (RSI) are all oscillators.
Oscillators work under the premise that as momentum begins to slow, fewer buyers (if in an uptrend) or fewer sellers (if in a downtrend) are willing to trade at the current price.
A change in momentum is often a signal that the current trend is weakening.
Each of these indicators is designed to signal a possible trend reversal, where the previous trend has run its course and the price is ready to change direction. Let’s take a look at a couple of examples.
We’ve slapped on all three oscillators on GBP/USD’s daily chart shown below. Remember when we discussed how to work the Stochastic, Parabolic SAR, and RSI?
If you don’t, we’re sending you back to fifth grade!
Anyway, as you can see on the chart, all three indicators gave buy signals towards the end of December.
Taking that trade would’ve yielded around 400 pips in gains. Ka-ching!
Then, during the third week of January, the Stochastic, Parabolic SAR, and RSI all gave sell signals.
And judging from that long 3-month drop afterward, you would’ve made a whole lot of pips if you took that short trade.
Around mid-April, all three oscillators gave another sell signal, after which the price made another sharp dive. Now let’s take a look at the same oscillators messing up, just so you know these signals aren’t perfect.
In the chart below, you can see that the indicators could give conflicting signals.
For instance, the Parabolic SAR gave a sell signal in mid-February while the Stochastic showed the exact opposite signal.
Which one should you follow?
Well, the RSI seems to be just as undecided as you are since it didn’t give any buy or sell signals at that time.
Looking at the chart above, you can quickly see that there were a lot of false signals popping up. During the second week of April, both the Stochastic and the RSI gave sell signals while the Parabolic SAR didn’t give one.
The price kept climbing from there and you could’ve lost a bunch of pips if you entered a short trade right away.
You would’ve had another loss around the middle of May if you acted on those buy signals from the Stochastic and RSI and simply ignored the sell signal from the Parabolic SAR.
What happened to such a good set of indicators?
The answer lies in the method of calculation for each one.
Stochastic is based on the high-to-low range of the time period (in this case, it’s hourly), yet doesn’t account for changes from one hour to the next.
The Relative Strength Index (RSI) uses the change from one closing price to the next.
Parabolic SAR has its own unique calculations that can further cause conflict.
That’s the nature of oscillators. They assume that a particular price movement always results in the same reversal.
Of course, that’s hogwash.
While being aware of why a leading indicator may be wrong, there’s no way to avoid them.
If you’re getting mixed signals, you’re better off doing nothing than taking a “best guess”. If a chart doesn’t meet all your criteria, don’t force the trade!
Move on to the next one that does meet your criteria.
How to Use Momentum Indicators to Confirm a Trend
So how do we spot a trend?
The indicators that can do so have already been identified as MACD and moving averages.
These indicators will spot trends once they have been established, at the expense of delayed entry. The bright side is that there’s less chance of being wrong.
On GBP/USD’s daily chart above, we’ve put on the 10 EMA (blue), 20 EMA (red), and the MACD. Around October 15, the 10 EMA crossed above the 20 EMA, which is a bullish crossover.
Similarly, the MACD made an upward crossover and gave a buy signal.
If you jumped in on a long trade back then, you would’ve enjoyed that nice uptrend that followed.
Later on, both the moving averages and MACD gave a couple of sell signals.
And judging from the strong downtrends that occurred, taking those short trades would’ve given huge profits.
We can see those dollar signs flashing in your eyes!
Now let’s look at another chart so you can see how these crossover signals can sometimes give false signals. We like to call them “fakeouts.”
On March 15, the MACD made a bullish crossover while the moving averages gave no signal whatsoever. If you acted on that buy signal from the MACD, you just suffered a fake out, buddy.
Similarly, the MACD’s buy signal by the end of May wasn’t accompanied by any moving average crossover.
If you entered a long trade right then and there, you might’ve set yourself up for a loss since the price dipped a bit after that.