To understand the difference between leading and lagging indicators, let us start at the beginning, and explain why there is a need to distinguish between leading and lagging indicators in the first place: There are two different types of technical indicators: Indicators that lead the market, and indicators that are lagging in relation to the market.
Leading indicators try to predict which event will happen. Most oscillators, for example, are leading indicators: They aggregate data to evaluate the strength of the current movement. Is the current movement weakening, they will alert you, so that you can search for further signs, and invest in the turnaround once it is happening. Lagging indicators, on the other hand, tell you what has already happened. A moving average, for example, will turn direction after the market has turned around.
When becoming a trader, you have to decide whether you want to follow trends or trade swings.
Depending on whether you decided to become a swing trader or a trend follower, you should rely on different indicators. Swing traders rely more heavily on leading indicators, and only use lagging indicators to filter out signals against the main trend direction, if at all.
Trend followers, on the other hand, rarely use leading indicators. Trend followers try to capture a trend in its entirety. Leading indicators, on the other hand, are mostly oscillators and create a signal with every swing. For trend followers, that is too many signals created by no significant change in market sentiment.
Trend followers need fewer signals that show a more significant change in market sentiment. The perfect way to get these signals is to use lagging indicators such as moving averages.
By using lagging indicators based on a medium to high number of periods, a trend follower can determine the overall market sentiment. A trader using a moving average based on 20 or (in longer time frames) even 50 periods, for example, can easily determine the overall market sentiment: If the moving average is pointing up, the market is in an uptrend. If the moving average is pointing down, the market is in a downtrend.
This example shows the strength and the weakness of lagging indicators: In trending periods, they are perfect to find out where the market is going. If you are planning on programming an automated trading programming with Meta Trader, all you need to follow a trend is a simple, medium to high period moving average.
During periods of sideways movement, however, lagging indicators are less helpful. If the market is alternating up and down movements randomly, it is only a matter of time until lagging indicators will follow its lead.
Again, think of a moving average. As the market is moving around roughly the same price level for a period of time, the moving average will step by step approach the current market price. Once it reaches the market price, every random swing upwards will turn the moving average upwards. A few periods later, the market will randomly swing downwards again, and turn the moving average downwards, too.
In that scenario, the moving average will create many signals. None of them, however, will result in a trend. That means your chances of winning a binary option based on those signals are small.
To trade lagging signals successfully, you need to filter their signals. You can either use another indicator to validate your main indicator’s signals (for example with the three moving average crossover technique), or validate the signals manually: If the market is in a trend, you follow the indicator. If the market is not in a trend, you ignore the indicator.