Leading and lagging indicators: what they are and how to use them in trading
Do you check the weather forecast before leaving home? A forecast tells you what’s likely ahead – but it isn’t always right. That’s like a leading indicator in trading. By contrast, a thermometer tells you your current temperature – it confirms what’s happening, but not what comes next. That’s like a lagging indicator. Traders use both: leading indicators to anticipate moves, and lagging indicators to confirm them.
This guide explains what leading and lagging indicators are, how to use them to make trading decisions, and provides examples of the most popular indicators.
What are leading and lagging indicators?
Indicators help traders understand the market. They are mathematical calculations that use past price and volume data. They are of two main types: leading and lagging.
Leading indicators give insight into potential future price movements. They give a signal before a trend happens. Think of them as a warning sign. They can show you a potential change, and can help traders prepare for market moves since they are forward-looking.
Lagging technical indicators confirm a trend. They give a signal after a trend has started. They are like a rearview mirror. They show you what has already happened, confirming if a trend is real. They help traders follow an existing trend since they are backward-looking.
The difference between leading and lagging indicators is their timing. Leading indicators are early, while lagging indicators are late. Also, leading indicators can be risky. They can give false signals. Lagging indicators are regarded by some as safer and more reliable.
Traders need both lagging and leading indicators in stock trading to get a full picture and identify trading opportunities. Using both also helps you avoid false signals.
Remember, technical indicators are not indicative of success – they just offer guidance based on historical price action. Past performance is not a reliable indicator of future results.
Use a demo account to practice technical analysis before applying it to the live markets. Open a demo account today.
Popular leading indicators in trading
Leading indicators try to predict future market movements. They can signal momentum shifts. They can also show potential trend reversals. This gives you an edge to plan your trades. But they are not always right, since the market could suddenly move in another direction due to some breaking news.
Here are some popular leading indicators:
1. New housing starts
This is an important economic indicator for investors. It measures new home construction. An increase can signal a strong economy, which, in turn, could signal future market growth.
2. Volume spikes
A sudden increase in trading volume can precede a big move. High volume confirms strong interest. It can predict a breakout or a reversal. On-balance volume (OBV) and volume-weighted average price (VWAP) are popular volume indicators.
3. Purchasing managers’ index (PMI)
PMI is a survey of purchasing managers and indicates economic health. A reading above 50 suggests economic expansion. A reading below 50 shows contraction. This can predict future economic growth.
4. Yield curve
The yield curve plots interest rates. Historically, an inverted yield curve (short-term rates are higher than long-term rates) has often predicted recessions, though past performance is not a reliable indicator of future results.
5. Sentiment indices
These measure traders’ feelings. The CBOE volatility index (VIX) is a popular sentiment index. High VIX readings show fear. This can sometimes predict a market bottom.
6. Market breadth
Market breadth looks at the number of advancing stocks versus declining stocks. A declining advance/decline (A/D) line during a market rally can predict a coming downturn.
7. Options data
Put/call ratios measure trading volume. High put volume shows fear. It can be a contrarian indicator. A very high ratio can signal a market bottom.
The main benefit of leading indicators is getting in early. Your chances of success increase if you enter a trend at the beginning. The main limitation is false signals. This can make them risky.
Learn more about leading and lagging indicators with our technical analysis guide.
Popular lagging indicators in trading
Lagging indicators confirm existing trends. They are about confirming price moves rather than predicting them. They tell you that a trend is already happening. This makes them safer to use.
Here are 10 popular lagging indicators:
1. Relative strength index (RSI)
The RSI measures momentum. It ranges on a scale of 0 to 100 and shows whether an asset is overbought or oversold. An RSI above 70 means overbought, and an RSI below 30 means oversold. So, readings above 70 and below 30 can signal a possible price reversal.
Learn more about a potential RSI trading strategy.
2. Moving average convergence divergence (MACD)
The MACD is a trend-following momentum indicator. A bullish crossover happens when the MACD line crosses above the signal line. This can predict an uptrend. A bearish crossover, when the MACD crosses below the signal line, can predict a downtrend.
Learn more about a potential MACD trading strategy.
3. Moving average (MA)
MA crossovers happen when a short-term MA crosses a long-term one. The Golden Cross is a popular example. It happens when the 50-day simple moving average (SMA) line crosses above the 200-day SMA. This predicts a strong uptrend.
Learn more about a potential moving average trading strategy.
4. Bollinger bands®
Bollinger bands® are placed around a moving average and show volatility. The bands expand when volatility is high and contract when volatility is low. In this way, they confirm a trend’s strength.
5. MACD histogram
The MACD histogram measures the distance between the MACD line and the signal line. A rising histogram confirms growing momentum in an uptrend. A falling histogram confirms growing momentum in a downtrend.
6. Unemployment rate
This economic indicator for investors shows the percentage of jobless people in a country. A falling unemployment rate confirms a strong economy, while a rising rate suggests a weakening economy.
7. Inflation rate
Inflation rate measures rising prices. High inflation can confirm an overheating economy, while low inflation can confirm a cooling economy.
8. GDP growth
Gross domestic product (GDP) measures the value of all goods and services in a country. It confirms the overall health of the economy. High GDP growth confirms a strong economy.
9. Balance sheets/earnings reports
These financial statements report a company’s past performance. Strong earnings confirm that a company is healthy, while weak earnings confirm that it is struggling.
10. Sales revenue
This is an important metric that shows how much a company sold. High sales revenue confirms a company’s success. It shows that the business is doing well.
11. Rate of change (ROC)
ROC measures the percentage change in price over time. A positive ROC confirms a strong uptrend, while a negative ROC confirms a strong downtrend.
Historical volatility
This measures how much an asset’s price has moved in the past. High historical volatility confirms that an asset is currently volatile. Low volatility confirms it is stable.
You can use lagging indicators in trend-following strategies. Wait for the trend to start, and then you use a lagging indicator to confirm it. This helps you enter the trade with more confidence. You can also use them with price action. For example, you might wait for the price to close above a moving average. This confirms an uptrend.
Learn more about the trading essentials for beginners to build your trading strategy.
How to combine leading and lagging indicators
The best approach is to use both leading and lagging indicators together. You can use a leading indicator to find an opportunity. Then use a lagging indicator to confirm it. This is the power of confirmation vs prediction. You predict a move and then confirm it.
Here are some examples of combinations:
RSI + EMA
You might see the RSI is moving out of the oversold region. This is a leading signal of a potential price reversal. Then, you wait for the price to cross above the 20-period exponential moving average (EMA), which is a lagging indicator. This will confirm whether the new uptrend has begun. You can then enter the trade.
Volume + MACD
When you see a sharp spike in volume, it is a leading signal. It predicts a potential breakout. Then you wait for the MACD lines to cross over. This is a lagging signal. It confirms that the new trend is starting. You can then enter the trade with more confidence.
Yield curve + earnings reports
When the yield curve inverts, it is a leading macroeconomic signal. It predicts a possible recession. You then wait for companies' earnings reports to confirm this. You look for declining revenue and profits, which is a lagging signal. Once confirmed, you can adjust your long-term investment strategy.
Pipeline (leading) + revenue (lagging)
A company’s future product pipeline is a leading indicator. It shows potential for future growth. You then wait for the company to report increased revenue. This is a lagging indicator. It confirms the success of the new products.
The best practice is to build a multi-indicator setup. However, don’t use too many. Two or three good indicators are enough, with one leading and one lagging. They should complement each other.
Application in different market contexts
Different markets behave differently. So, the best indicators can change depending on the asset.
Stocks
In a bull market, you might use lagging indicators like moving averages to confirm trends. In a volatile market, you might use leading indicators like the RSI to spot overbought or oversold conditions.
Crypto
The crypto market is very volatile. Leading indicators in stock trading, like RSI and volume, are very popular here. The volatility can lead to many false signals from lagging indicators.
Forex
Forex trends can last long. Lagging indicators like Bollinger bands and moving averages are popular for trend following strategies.
Commodities
Commodity prices are affected by supply and demand. Economic indicators for investors, like inventory levels and production data, are key. These are often leading indicators for price movements.
Which indicators work better depends on the market. In volatile markets, leading indicators can help you spot quick reversals. In trending markets, lagging indicators can confirm the trend.
Learn more about trading different asset classes with our market guides.
Choosing the right indicators for your strategy
Your trading strategy and its timeframe matter when choosing indicators. For instance, in swing trading, you hold trades for days or weeks. A mix of both leading and lagging indicators works well. You could use the RSI on a daily chart to spot a reversal. Then use a moving average to confirm the trend on a 4-hour chart.
In scalping, positions are held for minutes. You will need fast signals. Leading indicators like volume and moving average crosses are popular. You can use very short timeframes, like the 1-minute or 5-minute chart.
Positions are held for months or even years in position trading. So, you focus on long-term trends using economic indicators and earnings reports. These are often lagging. They confirm the long-term health of a company or economy.
Long-term investing is similar to position trading. You can use macroeconomic data like GDP and unemployment rates. These are mostly lagging. They confirm the overall economic climate.
Timeframes affect indicator usefulness. A moving average on a 5-minute chart is different from one on a daily chart. The shorter the timeframe, the more sensitive the indicator. You must adjust your settings for your timeframe.
Common mistakes when using indicators
Here are some common mistakes you must avoid to have satisfying trading experiences.
Relying on one type of indicator only
Do not just use leading or just use lagging indicators. You need both for a complete view. Using only leading indicators leads to many false signals. Using only lagging indicators means you will often enter trades late.
Ignoring market context
Indicators don’t work in a vacuum. You must understand the market. Is it a bull market? Is there a recession? Indicators can give different signals in different contexts.
Indicator overload
Do not use too many indicators. It can be confusing since some could give conflicting signals. This can lead to analysis paralysis. This is when you try to find the ‘perfect’ settings and fail to capture the opportunity.
Misinterpreting divergence
Divergence is when an indicator and price move in different directions. For example, the price makes a new high, but the RSI makes a lower high. This can signal a reversal. Misinterpreting this can lead to wrong trades.
So, use leading and lagging indicators together. Always confirm your predictions. This will help you make more informed trades. When you are ready to enter the markets, open a live account.
