Commander in Pips: Up until now, we’ve covered a lot of important topics, different indicators and other interesting parts. Today we start with another interesting part – leading and lagging indicators. Currently a lot of educational projects and material cover this issue not quite in the proper way. So, our task here is to meet you with a classical approach to categorization of different tools into lagging and leading groups, although this approach has some misleading issues. Second, show you the way of categorization that seems to be most correct to me.
To understand the advantages and disadvantages of indicators that we’ve discussed, we will separate them into two groups – yes, “Leading” and “Lagging”. Almost like in song by Chuck Berry “Reeling & Rocking”. The most common approach to this classification points that a leading indicator gives a signal before the new trend or reversal happens. As you’ve guessed already, a lagging indicator gives a signal at some time after the new trend starting has already passed. It’s like lagging behind the trend shifting or reversal point.
Pipruit: Hm, and why we need lagging indicators at all? We can use just leading ones and always will be anticipating the market.
Commander in Pips: Oh, you’re really a smart guy. This is the best idea that I ever heard. But here is very small problem with this idea of yours…
Pipruit: What problem?
Commander in Pips: Probably you will get in at the starting point of every trend, but only if the indicator will catch it correctly every time. And how do you think, is it possible at all?
Commander in Pips: That’s it. In fact, relying just on a single indicator without any detailed trading plan is more like a gambling than trading. Because here you do not need to think – the indicator gives a signal and you take action. That’s all. But at this point in our school you should already know that making money on Forex is a tough business, not gambling.
Pipruit: I guess not. We’ve studied already, that indicators have a tendency to fail from time to time, and we should not rely on any single tool.
Commander in Pips: That’s good. Let’s continue… Also there is an opinion that leading indicators are very sensitive to different splashes and fake outs, because they react fast even at the smallest changes in recent price action. This is like working with a short period MA. In other words, sometimes they could mislead you.
Pipruit: Yes, I remember that.
But we also have lagging indicators, and common approach tells us supposedly that they are not so prone to bogus signals. But lagging indicators form signals, when trend shifting has happened already and price action is clearly forming a new trend. The problem with using just lagging indicators (for confidence in trend shifting) is in fact, that very often a solid move happens during the initial period of a new trend and by applying only lagging indicators you can miss a lot of profit.
So, as you can see the same problem as with short period MA – EMA seems fast but too sensitive, while long period MA is smooth but too slow.
The major approach to classification creates two groups:
1. Oscillators, i.e. leading indicators;
2. Trend following (momentum) indicators, i.e. lagging indicators.
Sometimes they could support each other; sometimes they could oppose to each other, none of them should be used exclusively, but you have to understand their snags.
So, we will start from general approach to Leading and Lagging categorization, and then we discuss our approach.
Pipruit: What “our” approach?
Commander in Pips: We think that leading indicators are those that do not need any price action to appoint on support or resistance ahead of time, while lagging indicators do.
Pipruit: And do such indicators exist at all?
Commander in Pips: Sure, but not just indicators, but “tools” also…
Pipruit: Sounds intriguing…