Leading and Lagging Indicators
There are two basics types of technical studies in the analysis of the stock market: leading indicators and lagging indicators. However there exist the third group of technical indicators (informational indicators) that do not belong to the none of the above.
Leading Technical Indicators are the indicators that help to predict possible future trend. Many trading systems use these types of indicators to generate trend reversal signals. However, there is no guarantee that the analyzed security, index or market will reverse its trend after a signal is generated. The common problem with this type of technical studies is that in some cases a trade could be opened too early and the signal could be ignored (no reversal). Examples of such indicators could be volume based technical indicators.
Lagging Technical Indicators are the technical indicators that would rather follow a trend then predict its reversal. These studies are more reliable than the leading technical indicators. However they have other problem: in many cases a trade could be opened and closed when it is too late and the trend already in reversal movement. Example of these studies could be MACD, Moving Averages, etc.
The last category of Informational Technical Indicators does not predict trend reversals at all nor follow a trend. This group of technical indicators is used strictly to evaluate, describe the market, index or analyzed security. Average True Range, (ATR), Average Directional Index (ADX), VIX Volatility Index are examples of indicators from this category.
As a rule, a professional trading system developer would prefer using at least one indicator from each group. The leading indicators could be used to generate a signal and alert a trader about possible reversal. Then lagging technical indicator would be used to confirm this reversal and open or close a trade. The informational indicators would be used in professional trading system to adjust leading and lagging indicator to the current market which would provide better performance and filter fake signals: different indicators setting should be used in strong and weak trends as well as in different volatile periods.
Combination of lagging and leading indicators allows substantially increase profitability of a trading system. This union helps to eliminate fake signals generated by leading indicators and set more sensitive levels for lagging indicators. A simple trading system based on these indicators would look like:
1. Be ready when a leading indicator generated a signal;
2. Act (buy or sell) when a lagging indicator confirms the signal generated by the leading indicator;
3. Ignore the signal generated by the leading indicator if it is not confirmed by a lagging indicator.
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Find out about technical analysis of different indicators applied to the S&P 500, NASDAQ 100 and DJI to create index trading systems for stocks and options trading.