Wednesday, December 30, 2009

What is a Leading Indicator

Mario writes:

"how do you derive leading indicators for any chart? I have been reading John Murphy, but whatever he says as leading indicators (like MACD) have now turned out to be laggging indicators. Kindly help"

Interesting question.

Investopedia defines this as: "A leading indicator precedes price movements, giving them a predictive quality, while a lagging indicator is a confirmation tool because it follows price movement. A leading indicator is thought to be the strongest during periods of sideways or non-trending trading ranges, while the lagging indicators are still useful during trending periods. "

Therefore, a leading indicator is useful during trading ranges. Now, how do we know that we are in a range? This information is available only after some time has elapsed. So, we start using leading indicators after we perceive that prices are in a trading range. It is possible that the range may be getting over by the time we decide to use leading indicators. Therefore, a leading indicator may finally result in a whipsaw. All in all, there is confusion.

Since most indicators are derived from price, they cannot step ahead of price and predict it. Predicitve indicators must be non-price methods, like Fibonacci, Cycles, Waves. These tools use price as one of their inputs, while MACD, RSI and so on use price as their ONLY input.

For this reason, Fibonacci, waves, cycles are much in demand because they have this quality of telling us what future prices will be (If they are correct!). It follows that most of the time, these tools are not correct.

With indicators, leading indicators identify turning points, essentially acting as cycles.

How about this: If you perceive a trend has started, use lagging indicators like Moving Averages, MACD. If you assume we are in a trading range, use leading indicators like RSI, Stochastics, MACD. Yes, MACD can be used both as trend following and as a method to identify 'overbought' and 'oversold' levels. At turning points, you will get chopped, but there will be many trades where you will make money. Finally, your profits should exceed your losses.  Think about it.

4 comments:

pucchhu said...

Every thing agreed Sir

But for now

ONLY............


HAPPY NEW YEAR

gourv said...

Hello Sir,

Wish u and ur family a very very happy and prosporus new year 2010.

Regards
Gourav

MONEYVISTAS said...

Hi Sudarshn sir

Wish you happy new year with Health and Wealth.

Best regards
chandrasekhar

men said...

Dear Readers,
Where can one view historical option charts?
Thanks,