As their name implies, leading indicators are designed to lead price movements. Most represent a form of price momentum over a fixed look-back period, which is the number of periods used to calculate the indicator. For example, a 20-day Stochastic Oscillator would use the past 20 days of price action (about a month) in its calculation. All prior price action would be ignored. Some of the more popular leading indicators include Commodity Channel Index (CCI), Momentum, Relative Strength Index (RSI), Stochastic Oscillator and Williams %R.
Momentum Oscillators
Many leading indicators come in the form of momentum oscillators. Generally speaking, momentum measures the rate-of-change of a security's price. As the price of a security rises, price momentum increases. The faster the security rises (the greater the period-over-period price change), the larger the increase in momentum. Once this rise begins to slow, momentum will also slow. As a security begins to trade flat, momentum starts to actually decline from previous high levels. However, declining momentum in the face of sideways trading is not always a bearish signal. It simply means that momentum is returning to a more median level.
RSI
Momentum indicators employ various formulas to measure price changes. RSI (a momentum indicator) compares the average price change of the advancing periods with the average change of the declining periods. On the IBM chart, RSI advanced from October to the end of November. During this period, the stock advanced from the upper 60s to the low 80s. When the stock traded sideways in the first half of December, RSI dropped rather sharply (blue lines). This consolidation in the stock was quite normal and actually healthy. From these lofty levels (near 70), flat price action would be expected to cause a a decline in RSI (and momentum). If RSI were trading around 50 and the stock began to trade flat, the indicator would not be expected to decline. The green lines on the chart mark a period of sideways trading in the stock and in RSI. RSI started from a relatively median level, around 50. The subsequent flat price action in the stock also produced relatively flat price action in the indicator and it remains around 50.
Benefits and Drawbacks of Leading Indicators
There are clearly many benefits to using leading indicators. Early signaling for entry and exit is the main benefit. Leading indicators generate more signals and allow more opportunities to trade. Early signals can also act to forewarn against a potential strength or weakness. Because they generate more signals, leading indicators are best used in trading markets. These indicators can be used in trending markets, but usually with the major trend, not against it. In a market trending up, the best use is to help identify oversold conditions for buying opportunities. In a market that is trending down, leading indicators can help identify overbought situations for selling opportunities.
With early signals comes the prospect of higher returns and with higher returns comes the reality of greater risk. More signals and earlier signals mean that the chances of false signals and whipsaws increase. False signals will increase the potential for losses. Whipsaws can generate commissions that can eat away profits and test trading stamina.
Lagging Indicators
As their name implies, lagging indicators follow the price action and are commonly referred to as trend-following indicators. Rarely, if ever, will these indicators lead the price of a security. Trend-following indicators work best when markets or securities develop strong trends. They are designed to get traders in and keep them in as long as the trend is intact. As such, these indicators are not effective in trading or sideways markets. If used in trading markets, trend-following indicators will likely lead to many false signals and whipsaws. Some popular trend-following indicators include moving averages (exponential, simple, weighted, variable) and MACD.
The chart above shows the S&P 500 ($SPX)![[$SPX]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_uzpXMLXScXQDB1M5KKQWbl7PrrGkCLkFYQGsIKMpRKR1_dIpcsEUPVxbkjtJrTvLG-bRcjZlH-hwLSUCeavSrS0fSiYpkB_FPW8Ig9I8eS-w=s0-d)
with the 20-day simple moving average and the 100-day simple moving average. Using a moving average crossover to generate the signals, there were seven signals over the two years covered in the chart. Over these two years, the system would have been enormously profitable. This is due to the strong trends that developed from Oct-97 to Aug-98 and from Nov-98 to Aug-99. However, notice that as soon as the index starts to move sideways in a trading range, the whipsaws begin. The signals in Nov-97 (sell), Aug-99 (sell) and Sept-99 (buy) were reversed in a matter of days. Had these moving averages been longer (50- and 200-day moving averages), there would have been fewer whipsaws. Had these moving average been shorter (10 and 50-day moving average), there would have been more whipsaws, more signals, and earlier signals.
with the 20-day simple moving average and the 100-day simple moving average. Using a moving average crossover to generate the signals, there were seven signals over the two years covered in the chart. Over these two years, the system would have been enormously profitable. This is due to the strong trends that developed from Oct-97 to Aug-98 and from Nov-98 to Aug-99. However, notice that as soon as the index starts to move sideways in a trading range, the whipsaws begin. The signals in Nov-97 (sell), Aug-99 (sell) and Sept-99 (buy) were reversed in a matter of days. Had these moving averages been longer (50- and 200-day moving averages), there would have been fewer whipsaws. Had these moving average been shorter (10 and 50-day moving average), there would have been more whipsaws, more signals, and earlier signals.Benefits and Drawbacks of Lagging Indicators
One of the main benefits of trend-following indicators is the ability to catch a move and remain in a move. Provided the market or security in question develops a sustained move, trend-following indicators can be enormously profitable and easy to use. The longer the trend, the fewer the signals and less trading involved.
The benefits of trend-following indicators are lost when a security moves in a trading range. In the S&P 500 example, the index appears to have been range-bound at least 50% of the time. Even though the index trended higher from 1982 to 1999, there have also been large periods of sideways movement. From 1964 to 1980, the index traded within a large range bound by 85 and 110.
Another drawback of trend-following indicators is that signals tend to be late. By the time a moving average crossover occurs, a significant portion of the move has already occurred. The Nov-98 buy signal occurred at 1130, about 19% above the Oct-98 low of 950. Late entry and exit points can skew the risk/reward ratio.
The Challenge of Indicators
For technical indicators, there is a trade-off between sensitivity and consistency. In an ideal world, we want an indicator that is sensitive to price movements, gives early signals and has few false signals (whipsaws). If we increase the sensitivity by reducing the number of periods, an indicator will provide early signals, but the number of false signals will increase. If we decrease sensitivity by increasing the number of periods, then the number of false signals will decrease, but the signals will lag and and this will skew the reward-to-risk ratio.
The longer a moving average is, the slower it will react and fewer signals will be generated. As the moving average is shortened, it becomes faster and more volatile, increasing the number of false signals. The same holds true for the various momentum indicators. A 14 period RSI will generate fewer signals than a 5 period RSI. The 5 period RSI will be much more sensitive and have more overbought and oversold readings. It is up to each investor to select a time frame that suits his or her trading style and objectives.
Oscillator Types
An oscillator is an indicator that fluctuates above and below a centerline or between set levels as its value changes over time. Oscillators can remain at extreme levels (overbought or oversold) for extended periods, but they cannot trend for a sustained period. In contrast, a security or a cumulative indicator like On-Balance-Volume (OBV) can trend as it continually increases or decreases in value over a sustained period of time.
As the indicator comparison chart shows, oscillator movements are more confined and sustained movements (trends) are limited, no matter how long the time period. Over the two year period, Moving Average Convergence Divergence (MACD) fluctuated above and below zero, touching the zero line about 18 times. Also notice that each time MACD surpassed +80 the indicator pulled back. Even though MACD does not have an upper or lower limit on its range of values, its movements appear confined. OBV, on the other hand, began an uptrend in March 2003 and advanced steadily for the next year. Its movements are not confined and long-term trends can develop.
There are many different types of oscillators and some belong to more than one category. The breakdown of oscillator types begins with two types: centered oscillators which fluctuate above and below a center point or line, and banded oscillators which fluctuate between overbought and oversold extremes. Generally, centered oscillators are best suited for analyzing the direction of price momentum, while banded oscillators are best suited for identifying overbought and oversold levels.
Centered Oscillators
Centered oscillators fluctuate above and below a central point or line. These oscillators are good for identifying the strength or weakness, or direction, of momentum behind a security's move. In its purest form, momentum is positive (bullish) when a centered oscillator is trading above its center line and negative (bearish) when the oscillator is trading below its center line.
MACD is an example of a centered oscillator that fluctuates above and below zero. MACD is the difference between the 12-day EMA and 26-day EMA of a security. The further one moving average moves away from the other, the higher the reading. Even though there is no range limit to MACD, extremely large differences between the two moving averages are unlikely to last for long.
MACD
MACD is unique in that it has lagging elements as well as leading elements. Moving averages are lagging indicators and would be classified as trend-following or lagging elements. However, by taking the differences in the moving averages, MACD incorporates aspects of momentum or leading elements. The difference between the moving averages represents the rate of change. By measuring the rate-of-change, MACD becomes a leading indicator, but still with a bit of lag. With the integration of both moving averages and rate-of-change, MACD has forged a unique spot among oscillators as both a lagging and a leading indicator.
ROC
Rate-of-change (ROC) is a centered oscillator that also fluctuates above and below zero. As its name implies, ROC measures the percentage price change over a given time period. For example: 20 day ROC would measure the percentage price change over the last 20 days. The bigger the difference between the current price and the price 20 days ago, the higher the value of the ROC Oscillator. When the indicator is above 0, the percentage price change is positive (bullish). When the indicator is below 0, the percentage price change is negative (bearish).
As with MACD, ROC is not bound by upper or lower limits. This is typical of most centered oscillators and can make it difficult to spot overbought and oversold conditions. This ROC chart indicates that readings above +20% and below -20% represent extremes and are unlikely to last for an extended period of time. However, the only way to gauge that +20% and -20% are extreme readings is from past observations. Also, +20% and -20% represent extremes for this particular security and may not be the same for other securities. Banded oscillators offer a better alternative to gauge extreme price levels.
Banded Oscillators
Banded oscillators fluctuate above and below two bands that signify extreme price levels. The lower band represents oversold readings and the upper band represents overbought readings. These set bands are based on the oscillator and change little from security to security, allowing the users to easily identify overbought and oversold conditions. The Relative Strength Index (RSI) and the Stochastic Oscillator are two examples of banded oscillators. (Note: The formulas and rationale behind RSI and the Stochastic Oscillator are more complicated than those for MACD and ROC. As such, calculations are addressed in separate articles.)
Stochastics/RSI
For RSI, the bands for overbought and oversold are usually set at 70 and 30 respectively. A reading greater than 70 would be considered overbought and a reading below 30 would be considered oversold. For the Stochastic Oscillator, a reading above 80 is overbought and a reading below 20 oversold. Even though these are the recommended band settings, certain securities may not adhere to these ranges and might require more fine-tuning. Making adjustments to the bands is usually a judgment call that will reflect a trader's preferences and the volatility of the security.
Many, but not all, banded oscillators fluctuate within set upper and lower limits. The Relative Strength Index (RSI) is range-bound by 0 and 100 and will never go higher than 100 nor lower than zero. The Stochastic Oscillator is another oscillator with a set range and is bound by 100 and 0 as well. However, the Commodity Channel Index (CCI) is an example of a banded oscillator that is not range bound.
CCI
Pros and Cons of Centered and Banded Oscillators
Centered oscillators are best used to identify the underlying strength or direction of momentum behind a move. Broadly speaking, readings above the center point indicate bullish momentum and readings below the center point indicate bearish momentum. The biggest difference between centered oscillators and banded oscillators is the latter's ability to identify extreme readings. While it is possible to identify extreme readings with centered oscillators, they are not ideal for this purpose. Banded oscillators are best suited to identify overbought and oversold conditions.
