(source:stockcharts.com/Arthur Hill)

In Part 2 of our tutorial on indicators we will cover "Leading" and "Lagging" Indicators.

Leading Indicators :
As their name implies, leading indicators are designed to precede price movements. Most represent a form of rate of change in price momentum over a fixed look-back period, which is the number of periods used to calculate the indicator. For example, a 14-day RSI  would use the past 14 days of price action (about three weeks) 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.

What Do Most Leading Indicators Measure?
Keep in mind that most  Leading Indicators   are  actually some type of a  Momentum Oscillator. Consequently, they tend to measure the rate at which the price of the security is moving. The bigger the move the bigger the rate of change and vice versa. Things tend to become confusing when a security trades  within a  narrow flat range. Usually when that happens, "momentum" will begin to decline, reflecting the sideways movement. This action does not necessarily mean that the move has been exhausted and the current trend will change. 

Two KEY things by which "leading" indicators forewarn about the upcoming move:

1. Little price movement, yet a noticeable change in the indicator.

2. A divergence between price movement and the indicator.

Take a good look at the chart below. As you can see during the "consolidation" phase we had no actual decline in price, yet the RSI fell from 80+ to nearly 60 (a noticeable change) That is a Bullish sign! However, during the "Exhaustion" phase we had a negative divergence. Price moved higher, but the RSI moved lower, meaning the up-move was coming to its final conclusion. 

(source:stockcharts.com/Arthur Hill)

Conclusion: When using leading indicators you do not pay that much attention to their absolute value. An RSI reading of +90 it does not mean that the up-move is exhausted, conversely, an RSI reading of -90 it does not mean the down move is exhausted. What you are looking for is positive or negative DIVERGENCES between price action and the indicator. Furthermore, indicators are not infallible, thus you do not open a position until price actually moves as expected.

When do "Leading Indicators" work the best?

 Leading Indicators work the best in "trading markets" only in tandem with the primary trend in place, 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. Many people lost money buying into NASDAQ during the decline from September 2000 to April 2001, because  they falsely used leading indicators to identify "oversold" points! In a market that is trending down you use these indicators to identify "overbought" points to go short!

Trending Up>Oversold Condition>Buying Opportunity

Trending Down>Overbought Condition>Selling Short Opportunity

Lagging Indicators: 

As their name implies, lagging indicators follow the price action and are commonly referred to as trend-following indicators. These kind of indicators confirm that the current trend is still intact, but they provide no clue whether it is about to change or not. Consequently, Trend-following indicators work best when markets or securities are in  strong trends. The most commonly used lagging indicators are based on moving averages. It should be noted that these indicators are highly inaccurate when used in "trading markets" In all likelihood they will result in a series of losses if they are used to generate entry/exit signals.

(source:stockcharts.com/Arthur Hill)

The chart above shows the S&P 500 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.

Advantages  and Disadvantages  of Lagging Indicators

There are three main advantages in using these types of indicators: a) They are very easy to set up and follow, thus, even relatively inexperienced traders can use them with little or on difficulty. b) Assuming  the trend develops into a strong one, the probability of getting "whipsawed" is rather small. c) They tend to be excellent confirming indicators.

The obvious disadvantage is that they rarely give a warning signal, plus, as we already mentioned earlier if they are used in a "trading" type of market they will result in plenty of false and unprofitable signals.

(source:stockcharts.com/Arthur hill)