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Leading Indicators

In the world of technical analysis, Leading indicators such as the Stochastic or RSI oscillators, are used to try and predict price movement.

The use of Leading & Lagging indicators is not limited to technical analysis and there are a variety of economic indicators, such Wage, Inflation, Employment or Consumer Confidence produced by the bodies such as the UK National Statistics office, the US Department of Labor, or the Consumer Confidence Board. As with the technical analysis indicators, these indicators are are used to try determine future market direction. In this help section we will focus on leading technical analysis indicators and their associated characteristics.

Leading indicators are typically used to provide an indication as to how 'overbought' or 'oversold' a market is. The basic premise associated with using leading indicators is that when a market is considered oversold it will re-bound and when it is considered overbought it will pull-back. Leading indicators are best suited to establishing entry and exit points based on price pivot points within an established trend, however for higher risk investors they can be used to try and identify price pivot points where a trend is potentially about to change direction. Lagging Indicators on the other hand are best suited to establishing the direction of a trend.

Consider the following EURUSD chart that represent the Price and corresponding Stochastic chart using a daily interval over a 3 month period:

Stochastic Leading Indicator 1.png

In this example the Stochastic indicator works well as a leading indicator when the EURUSD was largely trading sideways and trending between highs and lows. On each occasion when the Stochastic was oversold i.e. below 20, followed by a positive crossover, it corresponded with a price low; when the Stochastic was overbought, i.e. above 80, followed by a negative crossover, it corresponded with a price high. You can use timetotrade to set up your own Stochastic Alerts that will notify you when the Stochastic is overbought or oversold followed by a positive or negative crossover; click here to learn more.

The Stochastic indicator can produce false signals when a stock is trending between a narrow range of price movement in an upwards or downwards trend i.e. if the price movement is establishing a rapid series of lower highs and lower lows, or higher highs and higher lows, within a tight range of movement. For example, when the GBPUSD was in a strong downward trend in 2008, the stochastic indicator provided a series of false overbought long entry signals as illustrated:

Leading indicators stochastic 1.png

As another example, the stochastic indicator provided a false long exit signals when the USDJPY was rallying in 2012/2013 when the overall trend was still positive as illustrated:

Leading indicators stochastic usdjpy 2.png

The main advantage that leading indicators have over lagging indicators is that they provide an indication of when a market is overbought or oversold. However as the last two charts illustrated, a market can remain overbought or oversold for an extended period of time. Good practice therefore is to combine the use of leading indicators with lagging indicators to establish for example times to buy in an upward trend, or sell in a downward trend.

Another example of a leading indicator is the RSI oscillator. Typically traders use the RSI with a period of 14 i.e. the RSI calculations when the period is 14, are based on 14 price interval data, therefore if looking at a daily interval Price chart the RSI will be based on 14 days of historical price data. Using an interval period of 14, the RSI is typically considered overbought when greater than 70 and oversold when less than 30. If you look at the price movement of the EURUSD each time the RSI fell below 30 and rebounded it is associated with a low price pivot point and likewise when above 70 if is associated with a high price pivot point.

Leading indicators rsi 1.png

Leading indicators are most effective when a market is oscillating between support and resistance levels or trend lines within an established trend. A very practical applicable of leading indicators such as the RSI is to help establish key points of support and resistance within price channels. For example if we re-examine the previous RSI chart, note how the key points of support and resistance for the Trend Lines align with the RSI being over bought or oversold:

Leading indicators rsi 2.png

Lagging indicators are better suited to establishing the direction of a trend. Leading Indicators are better suited for timing entry and exit trades within a trend. It can therefore be quite effective to combine a Lagging Indicator such as a Moving Average with a Leading Indicator such as RSI. Continuing with the RSI example, the following chart shows the 100 Period Moving Average overlaid on the Price chart.

Leading indicators rsi 3.png

If the Moving Average is typically forming lower lows, the overall price trend can be considered bearish. Strategies where you sell to open a position (short), work best in bearish markets. Each time the RSI is overbought in a bearish market, it presents an opportunity to sell to open a position and then when the market becomes oversold it can be a good time to close the position. If the overall trend is bullish then it is typically best to buy to open a position when the market is oversold and close the position when overbought. You can use timetotrade to create alerts that will notify you when indicators such as the Moving Average are forming higher highs or lower lows, combined with the RSI being oversold or overbought.

To learn more about the timetotrade charts and alerts:

Want to create a custom indicator, alert or trading strategy, but don't know how? No problem - post a question on the forum or contact us. Go to the Ask A Question section on the timetotrade forum to see the type of alerts that timetotrade users are creating:

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