Leading Indicators
From Timetotrade
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' an equity is. The basic premise associated with using leading indicators is that when an equity 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 with 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 General Electric (GE) charts that represent the 2 year price and corresponding Stochastic charts based on a weekly interval period:
In this example the Stochastic indicator works well as a leading indicator when GE was bouncing between highs and lows between October 2005 and the end of 2006. On each occasion when the stochastic was heavily oversold i.e. at or near 0, it corresponded with a price low and when the stochastic was heavily overbought, i.e. at or near 100 it corresponded with a price high.
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 GE was in a strong downward trend between May 2005 and September 2005, as illustrated with the red downward trending arrow on the GE price chart in the image above, the stochastic indicator provided a false long entry signal in June 2005. This was repeated when GE was in a strong upward trend between July 2006 and January 2007, as illustrated by the red upward trending arrow on the GE price chart in the image above, as once again the stochastic indicator provided a false long exit signal in October 2006 when the overall trend was still positive.
The main advantage that leading indicators have over lagging indicators is that they provide an early indication of a change in price movement, as a price pivot point is being formed, not afterwards when a trend has been established. It should be noted that when using a price pivot point to establish an entry point the overall trend should be considered. There is greater risk associated with using leading indicators to establish when a long term trend is about to change as it can produce false entry or exit signals. A safer use of leading indicators is to establish entry and exit points for rolling a stock within a trend that is already established.
Another example of a leading indicator is the RSI oscillator. Typically traders use the RSI with an interval period of 14 i.e. if the charts displayed are based on a weekly interval period, the RSI calculations when the period is 14, are based on 14 weeks 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 QQQQs each time the RSI fell below 30 and rebounded it is associated with a price low.
Leading indicators are most effective when an equity is bouncing between support and resistance levels or trend lines within an established trend. Lagging indicators are better suited to establishing trends. For example the 100 day exponential moving average illustrated on the QQQQ's price chart above, clearly indicates that the overall price movement of the QQQQ's is upwards however if you where to base you entry and exit investment timing on each time the price rose above or fell below it you would always be late entering and exiting your position. The RSI leading indicator helps you identify entry and exit points within the upward trend.
More information on how to use the timetotrade system to create alerts against Technical Indicators can be found on the Creating an Alert pages.
You can use timetotradeto create alerts notify you when Stochastic and RSI investment conditions are met using the alert triggers beside each chart.
Further Reading
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