Technical analysis tools can be generally divided into two types. The first type will be lagging indicators and the second one – leading indicators. On most trading platforms you will find a wide choice of both kinds. It is important for your trading though, that you know what is the difference between them and when it is best to use them.
What are the lagging indicators?
The lagging indicators are giving the information with a small lag. The calculations are based on the average price from the past movements. When you are using this type of indicators, you will notice that the confirmation of the favourable situation to enter the position comes a little bit later than the action itself.
You will find supporters and opponents of these tools. The supporters will argue that it is worth to wait for a confirmation of the entry point. The opponents claim it is the waste of precious seconds.
The examples of the lagging indicators:
- Simple Moving Average
- Relative Strength Index
- Stochastic Oscillator
- Moving Average Convergence Divergence.
What are the leading indicators?
This type of indicators is also measured on the basis of the former price. The difference is that they are producing the signals for the situations yet to come. This ensures that the trader will enter a transaction at a very precise moment when the forecasting movement occurs.
Again, there are supporters and opponents of the leading indicators. Some believe that using this kind of indicators save valuable seconds so that you can enter the trade exactly at the time of the expecting change. But the second group says that there is a danger of false signals. And that is true. Sometimes the signals will be valid and you will gain high profits. But occasionally, the signal would be incorrect and so much anticipated breakout or reverse would not happen.
Some of the most commonly used leading indicators are:
- Support and resistance levels
- Donchian Channels
- Fibonacci retracements
Strengths and weaknesses of the lagging and leading indicators
The lagging indicators
- Their reliability is high because they are giving the signals to enter the position after the situation has really occurred.
- The danger of false signals is very low. At the same time the probability of winning increases.
The leading indicators
- A trader opens a position without any delay that is at precisely the correct point because the signals predict the future movements.
- The leading indicators serve to target higher probability positions because they detect key levels.
The lagging indicators
- There is obviously a delay in the signals produced with the lagging indicators. It may result in missing out on part of the pips.
- The lagging indicators do not detect key levels.
The leading indicators
- They give the signals for the anticipated movements that is why they can be incorrect at times. The markets change at a fast pace sometimes.
- The beginners may turn to them reluctantly as they tend to be used in the more sophisticated analysis.
Selection of the appropriate indicator
Both, lagging and leading indicators have their advantages and disadvantages. No one can say this one is better and that one worse. All depends on individual preferences and trading skills.
If you are at the beginning of the trading journey, you may want to start with the lagging indicators. They are more secure as the signals from them are visible after the situation has taken place. The lagging indicators will also be a good choice for investors who favour long-term transactions.
However, if you have some experience and you wish to act fast without wasting time on waiting for the confirmation, you should choose the leading indicators. Remember to secure your position by setting a stop loss.
Which type of indicators to choose is very much individual decision. You should always make thorough research and take your abilities into consideration. Naturally, you want to make money and you want them fast. That is why you may think the leading indicators are better. But do not forget that they come with higher risk.
The most important thing is that you know what two types of indicators are and what strengths and weaknesses they have. Also, you can use more than one tool at a time. For example, you can employ a combination of moving average with the Fibonacci levels or support/resistance lines.
Most of the brokers provide demo accounts. This is a very useful feature where you can practice what you have just learned. Try different tools and various combinations. Define your trading style and move to the real account with confidence.
Enjoy the journey!