Trading indicators can be classified as leading indicators, lagging indicators, or even both, based on the type of information they provide and how fast they respond 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. Knowledge can also help you better interpret market events based on the indicators you use.
What are the leading and lagging indicators?
Lead and lag indicators are technical indicators that give cryptocurrency traders an idea of what might 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 main 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 predict future price movements. Leading indicators can help you enter trends early by providing favorable trade entry and exit points. They are often more insightful for technical analysis because they can help you in your quest to enter high probability trades.
Lagging indicators are also known as trend indicators simply because they follow market trends. These indicators focus on historical data only and do not suggest what might happen next in the market. They use the average of previous price data to inform traders about market events.
5 Examples of early and late 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 determine entry, stop-loss and take profit points. Fibonacci retracement works best in a trending market.
If the price starts to fall or retrace in an uptrend, traders using the Fibonacci retracement tool will draw the retracement line to connect the last relevant swing high and low. This would help them see invisible support levels in the market, making it easy to determine where the price might reverse and continue the uptrend.
Main indicator: candlesticks
A candle shows the open, close, high and low prices of a market over a specified period. Each candlestick has specific information that it embodies. An experienced trader understands information and uses it to navigate the market. In other words, 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. Common candlestick patterns include doji, wrap-around candlesticks, spinning tops, hammers, and pin bars.
Lagging Indicator: Moving Averages
Moving averages identify the trend and direction of a cryptocurrency market. The moving average information is generated using previous price points, i.e. historical market data.
Moving average lines generate buy and sell signals when they cross, although traders cannot rely on them for the best trade revenue. This is because by the time the moving average lines show buy or sell signals, the price movement must have started a little earlier then, making any response to the moving average signal lagging behind.
Leading and Lagging Indicator: Bollinger Bands
Bollinger bands are made up of a moving average, which acts 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. Therefore, they buy when the market is near or below the lower range and sell when it is near or above the upper range.
Bollinger bands, just like the RSI (see below), are inherently lagging indicators because they move after the price has moved. They only react to the price movement. However, the outer bands can function as leading indicators as they suggest when the price might reverse.
Leading and Lagging Indicator: Relative Strength Index
The Relative Strength Index (RSI), another inherently lagging indicator, tells cryptocurrency traders when a market is overbought or oversold. The RSI fluctuates between 0 and 100, generally calculated over a period of 14 days. A scale above 70 is considered overbought and below 30 is oversold. The RSI also provides information on who is in control of the market. Traders usually take a scale above 50 as the buyers market and below 50 as the sellers market.
The main problem with RSI dependence, just like other lagging indicators, is that the signals usually arrive late. The market must have been bullish for a while before reflecting on the RSI chart.
The RSI can also act as a leading indicator, showing traders what could happen in the market. Let’s consider the case of the RSI divergence. The divergence of the RSI 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 event of an RSI divergence, the RSI shows a change in market momentum before it is reflected in the price, thus functioning as a leading indicator.
How to use the lag and lead indicators
From the categorization above, you can see that some cryptographic technical analysis indicators function 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 any leading indicators they find useful. The categorization is primarily functional, as the choice of how to use them depends on your cryptocurrency trading strategy.
Now that you know how leading and lagging indicators work, you can better interpret the chart information 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 useful for determining the entry and exit points of the trade.
On the other hand, lagging indicators are useful when looking at historical data and how prices have moved over time. However, nothing prevents you from using the information to predict future market events.
No indicator should be used as a standalone indicator. You have to combine it with other tools to make better trading decisions.
As it was shown
Having understood what lead 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 depends only on how best your strategy works. Of course, we can’t deny that knowing how they work and how to interpret the data they provide will be of benefit to you when doing your market analysis.