Using indicators as part of a trading strategy is very common for traders. However, they must be interpreted correctly. Indicators can mimic each other, causing confusion and mixed trading signals. This article will outline how to get the most out of your indicators by selecting the perfect balance for each specific indicator type.
Leading Indicators Vs Lagging Indicators
There are two significant classifications of indicators: leading and lagging. A leading indicator is a class of indicator that attempts to predict an asset’s future trend before it happens. This means (in an ideal world) a leading indicator can indicate a future direction before it happens.
A lagging indicator is a class of indicator which confirms the price trend of an asset. Traders use lagging indicators to ensure the price direction before going into a trade to ride the current trend to profit.
The main difference between the two classes of indicators is that leading indicators react to prices more quickly, and lagging indicators respond more slowly. Due to this, leading indicators can sometimes present false signals, and lagging indicators may confirm the trend too late.
Momentum Indicators
Momentum indicators measure the rate at which the price of an asset rises or falls. By using momentum indicators, traders can gauge the strength or weakness of an asset’s price and trade accordingly. When the price of an asset shows weakness, a sell signal will flash, and when the price of an asset shows strength, a buy signal will flash.
Popular Momentum Indicators:
- Moving Average Convergence Divergence (MACD) — A lagging indicator.
- Relative strength index — A leading indicator.
Volume Indicators
Volume refers to the amount an asset is traded in a certain period. Volume can be thought of as an enthusiasm meter for the markets. Typically when volume is rising along with prices, the market is considered strong. On the other hand, when volume increases and prices go down, the market is deemed to be weakening.
Popular Volume Indicators:
- On-Balance Volume (OBV) — A leading indicator.
- The Klinger Oscillator — A leading indicator.
Trend Indicators
Trend indicators use price data to gauge whether an asset is in an uptrend or a downtrend. They generally smooth out price action to display an objective measure of the general trend of the asset. Trend indicators are often used by traders looking to ride a price wave in one direction or another.
Popular Trend Indicators:
- Moving Averages — A lagging indicator.
- The Ichimoku Cloud — A leading indicator.
Volatility Indicators
Volatility indicators help gauge whether an asset’s price is in a period of low or high volatility. For the price to move significantly in either direction, high volatility is required, meaning above-average volatility is desired. When there is low volatility, the price tends to move sideways, creating less opportunity for profit.
Popular Volatility Indicators:
- Bollinger Bands — A lagging indicator.
- Average true range (ATR) — A leading indicator.
How to use Indicators to Perfect your Trading Strategy
The most effective way to use indicators is to combine 2–4 different types to gather clues to make a case for a trade. The keyword is different. Suppose you wanted to use the Relative strength index (RSI) with the Stochastic oscillator as your strategy. In that case, they are both leading momentum indicators. They essentially tell you the same thing. This means if you saw a buy signal on both indicators, you still only have one piece of evidence instead of two.
The goal is to have multiple indicators in agreement rather than conflicting with one another. Suppose you used On-Balance Volume (OBV) with the Relative Strength Index (RSI) and the Moving Average Convergence Divergence (MACD). You would be using a leading volume indicator, a leading momentum indicator, and a lagging momentum indicator. Using this strategy, if you saw rising/spiking volume combined with a buy signal on the MACD and RSI, you would have three pieces of evidence telling you price could be headed upwards. Increasing the probability of your trading thesis being correct.
Important to note: No single trading indicator has a 100% hit rate, nor should you make a trade based on any signal indicator’s buy or sell signal. Trading indicators should act as additional evidence to support your overall trade thesis.
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