Technical analysis uses many indicators to predict future market movements. To make sense of the wealth of indicators, traders need to classify them. One of the most popular methods of classifying technical indicators is into lagging and leading indicators.
Prominent examples of lagging indicators are moving averages and Bollinger Bands. Lagging indicators follow market movements, which means that they indicate a movement after it has happened.
While this kind of indicator is essential to a number of trading strategies, especially for trend followers, many binary options operate with such short expiration times that they rely more heavily on the other type of indicators: Leading indicators.
Leading indicators precede market movements. Two of the most popular leading indicators are the relative strength index (RSI) and the stochastic oscillator.
Leading indicators work especially well during periods of sideways market movement without trends. This is due to the fact that many leading indicators are oscillators.
Oscillators create many trading signals. In a trend, usually the smaller part of these signals is in the direction of the main trend. The bigger part, however, is in the opposite direction of the trend. Unless you are using a tailor made strategy for this kind of signal, these signals will likely result in lost trades.
In a sideways movement, however, lagging indicators are almost useless. Since the market has no clear direction, they will randomly indicate anything. None of these indications, however, can make for valid predictions about future market movements.
This situation is where leading indicators thrive. Oscillators can use their oversold and overbought areas to predict where the market will turn around in both directions. With this kind of indicator, you can find good trading opportunities and keep making money in an environment where other indicators fail you.
How to use leading indicators
To help you make money with leading indicators, follow these three simple steps:
1) Determine the market situation
To know whether leading indicators are the right type of indicator you should use, you first have to determine the current market environment. Is the market in a trend or is the market in a non-trending sideways movement?
2) Make sure to choose the right type of indicators
Depending on your diagnosis, you should rely more heavily on lagging indicators for trending markets and leading indicators for non-trending markets. If you rely solely on the wrong kind of indicator, you will lose most of your trades and in the process lose most of your money. To avoid losing money in trending markets, you need to find a way to adapt your leading indicator.
3) Adapt you indicator to its surroundings
If you plan to use an indicator during market environments it is not perfect for, make sure to compensate for the indicators weakness. You can do that either manually, by simply ignoring signals that do not fit the market environment, or automatically by using a second indicator that eliminates a part of the signals.
If you are using an oscillator during a trending market period, you could use a high-period moving average to determine whether the market is moving up or down. If the moving average is pointing upwards, ignore any short signal by the oscillator. If the moving average is pointing downwards, ignore all long signals created by the oscillator. If the moving average is pointing upwards, ignore all short signals created by the oscillator.
Compensating for the disadvantages of lagging indicators in non-trending periods, on the other hand, is more difficult. Leading indicators cannot help you with that. One possible approach could be to use the three moving averages crossover technique, which eliminates many of the false signals created by a two moving average crossover technique.