Leading and Lagging Indicators in Forex

Technical indicators computed from market observables can provide forex market analysts and traders with a useful way to generate objective trading signals. Technical analysts have also long known about the tendency of certain technical indicators to lead or lag an asset’s price action. 

While most forex traders prefer to use leading indicators over lagging indicators to provide trading signals, leading and lagging indicators both have a part to play when analyzing the forex market from a technical perspective. 

Read on for more information on leading vs. lagging indicators and how you can use such helpful forex indicators to enhance your currency trading profits. 

What Are Leading Indicators?

Leading indicators are technical indicators computed from market observables like price, volume and open interest that tend to lead the price action, rather than follow it. 

Leading indicators have particular value when attempting to predict future price moves in a market. This feature of leading indicators can make them useful for generating objective trading signals. 

What Are Lagging Indicators?

Like leading indicators, lagging indicators are also computed from market observables. They have a tendency to follow the price action rather than lead it, however. 

This delay or lag typically makes lagging indicators less useful for generating trading signals than leading indicators. They are instead typically used by forex traders to provide information about recent market conditions, such as directional movement and volatility. 

Leading vs. Lagging Indicators: What’s the Difference?

Certain technical indicators tend to produce signals that lead the market, while others give signals that lag behind the market. This is why these indicators are known as leading and lagging indicators respectively. 

The main difference between these leading and lagging technical indicators is that leading indicators tend to lead the price action and hence have predictive value while lagging indicators tend to follow the price action and lack that predictive value. 

Technical forex traders will usually select leading indicators to incorporate into their trading plans because the signals these indicators generate can help them predict future currency market moves with a significant degree of accuracy. 

Lagging indicators can also be useful to forex traders but typically more as a way of determining what sort of market conditions have prevailed over the recent past. 

Popular Leading Indicators

Leading indicators used by many technical traders include oscillators and volume signals. The manner in which leading indicators provide signals and how these signals can lead forex traders to make reasonable predictions for future exchange rate movements is explained in further detail below.  

Relative Strength Index (RSI)

The Relative Strength Index (RSI) first appeared in the 1978 book “New Concepts in Technical Trading Systems” by J. Welles Wilder. Since its introduction, the RSI has become one of the most widely-used momentum oscillators, and it remains a key component of many forex trading systems. 

The RSI is a bounded oscillator that generates a reading between 0 and 100. The RSI is calculated by taking the magnitude of all recent market advances and comparing them with the magnitude of all recent market declines. 

The key parameter specified for the RSI is the number of time periods. The most common value is 14 periods since that was originally recommended by Wilder.

The RSI is most commonly used as an indicator of overbought and oversold conditions in the market. A minimum RSI reading of 70 qualifies for an overbought market, while a maximum RSI reading of 30 would indicate an oversold market. 

Furthermore, if the RSI exceeds the 30 level after falling below it, then this would indicate a bullish signal. If the RSI dropped below 70 after exceeding it, then this would indicate a bearish signal. 

Divergence seen in the RSI index relative to the market exchange rate is also often used as a signal generator. Such divergence suggests a loss of momentum and often precedes a reversal in the exchange rate’s direction.  

For example, if the exchange rate makes a new high but the RSI fails to do so, then that demonstrates bearish divergence. Conversely, if the exchange rate makes a new low but the RSI fails to do so, then that shows bullish divergence. 

Other ways forex traders use the RSI can involve looking for trends or chart patterns on the RSI just as you might on an exchange rate chart and with a set of similar expected outcomes. 

You can watch for a crossover of the RSI’s center line. Typically, an RSI reading over 50 indicates that average gains outpace average losses, while a reading below 50 indicates that average losses outpace average gains. 

Williams %R

The Williams’ Percent Range or Williams’ %R oscillator was developed by Larry Williams to help traders more easily identify oversold and overbought market conditions. The Williams %R oscillator does this by tracking the relationship between a currency pair’s closing exchange rate relative to a range observed over a given time period. 

This indicator has an excellent track record for turning down just before a major top or turning up just before a major bottom, which makes it significant as a leading technical indicator.  

The Williams %R is a bounded oscillator with a scale that ranges from 0 to -100. An overbought reading ranges from -20 to 0, a neutral reading ranges between -20 and -80 and an oversold reading ranges from -80 to -100.

Many technical forex traders who use the Williams %R prefer waiting until a reversal in exchange rates occurs before establishing a trading position based on the indicator.  For example, if the Williams %R indicator was reading overbought at -15 for a particular exchange rate, this might not be the optimum level to sell into without downside confirmation first. A trader seeing this occur might wait for the indicator to return from overbought levels and sell once it crosses below the -20 level. 

Stochastic Oscillator

Originally developed in the late 1950s by George C. Lane, the Stochastic Oscillator or Stochastics technical indicator has some similarities to the Williams %R oscillator. The oscillator was developed by Lane to help traders identify extreme overbought and oversold conditions in the market.  

The scale of the Stochastics indicator ranges from 0 to 100. It gives an overbought reading between 80 and 100 and an oversold reading between 0 and 20.  

The Stochastic Oscillator tracks the relationship between the market close relative to the high-low ranges observed for a particular number of time periods. When a currency pair’s exchange rate regularly closes at the top of the indicator’s range, this indicates an accumulation phase where buying pressure builds up. Conversely, when the string of closes approaches the bottom of the indicator’s range, this indicates distribution where selling pressure is taking place. 

The three types of Stochastic Oscillators commonly used by traders are Fast, Slow and Full Stochastics with each of these having %K and %D lines. The %K line is related to the market’s close compared with the high-low range observed over a specific number of time periods. The %D line represents a moving average of the %K line, and it is commonly used for generating trading signals. 

The Slow Stochastic smooths out false signals by taking a moving average of the Fast Stochastic. The Full Stochastic indicator uses a third parameter to avoid taking that extra step. 

Traders typically use a version of the Stochastic Oscillator to generate trading signals. When the %K line moves above the %D line, the indicator provides a buy signal, and when the %K line moves below the %D line, a sell signal is generated. Using this simple signal method may lead to some unsuccessful trades before it indicates a profitable one. This disadvantage can be dealt with by looking for a divergence between the oscillator and the exchange rate when the oscillator lies in overbought or oversold territory. 

For a buy signal based on bullish divergence with the Stochastics in oversold territory below 20, the exchange rate would need to make two lower lows, but the indicator would fail to make a new low when the exchange rate makes its second low. 

Similarly, for a sell signal based on bearish divergence with the Stochastics reading overbought above 80, the exchange rate would have to make two higher highs, but the Stochastics indicator would fail to make a second higher high when the exchange rate does. 

On-Balance Volume (OBV)

The On-Balance Volume or OBV indicator was first introduced by Joe Granville in his 1963 book entitled “New Key to Stock Market Profits.” This indicator was among the first to measure volume flows as positive or negative in the stock market. 

The OBV indicator has no numerical parameters and is generally plotted in an indicator box under the exchange rate. The direction of the trend and the upward or downward slope of the indicator relative to that of the currency pair’s exchange rate are what forex traders look for in this indicator to give them an idea of future exchange rate moves.

Keep in mind that accurately calculating volume in the over-the-counter forex market is considerably more complex than for exchange-traded stocks or futures since no single source of daily currency market transaction data exists. When volume indicators like OBV appear on exchange rate charts, they are usually based on local rather than global trading volumes.

The basic premise behind using the OBV indicator is that volume changes precede the exchange rate changes seen in the forex market. The indicator is calculated for a particular period by either adding the traded volume if the market closes up or subtracting the traded volume if the market closes down.  

A single line representing the OBV is formed after arriving at a total by adding and subtracting volume figures. The OBV line can then be plotted in an indicator box below the exchange rate and used to identify divergences and confirm trends. The OBV indicator can then be used to show the changes in volume that characteristically precede an exchange rate move. 

OBV also gives forex traders useful information on the direction of the exchange rate. An upward-sloping OBV indicates a strong rising trend that displays increasing volume on up days. Conversely, a falling OBV indicates a viable downtrend with increasing volume on down days. In addition, many OBV traders look for divergence between the indicator and the exchange rate. 

For example, if a currency pair’s exchange rate rallies on declining volume, then this bearish divergence indicates a waning uptrend. This situation could make future rallies unsustainable, suggesting that the downside has become the more probable direction. 

When a pair’s exchange rate declines on contracting volume to show bullish divergence, the downtrend appears to be waning. This suggests that further downside has become less likely, so a corrective rally could ensue.

3 Popular Lagging Indicators

Lagging indicators commonly used by technical traders include various moving averages and volatility measures like the Bollinger Bands indicator. Since lagging indicators typically lack the predictive power of leading indicators, they are less frequently used to generate trading signals and more often used to provide a quantified sense of market conditions such as trending behavior or volatility risk.

Moving Averages

One of the most popular indicators used by technical forex traders to identify trends involves calculating one or more moving averages of a currency pair’s exchange rate. Moving average plots the average exchange rate taken over a set time period as it progresses through time. The moving average is depicted as a single line superimposed over the exchange rate on a chart.  

Forex traders typically use closing prices to calculate moving averages. This results in a smooth line superimposed over the exchange rate chart that tends to lag behind the actual exchange rate levels seen in the market. 

The three types of moving averages commonly used by forex traders include: 

• Simple MA (SMA): A simple moving average is an unweighted average of exchange rates observed from the beginning of the time period. This averaging process gives equal weight to all closing exchange rate data observed during the chosen time period. 
• Weighted MA (WMA): A weighted MA gives emphasis to some data used in the averaging process. Most analysts will weight recent data more heavily since it carries more weight than more distant data points when predicting future exchange rates.  
• Exponential MA (EMA): An exponential MA also places the greatest emphasis on the most recent data, although the level of weighting reduction between one data point and the previous data point is not consistent but instead falls off exponentially. 

In general, an SMA tends to lag exchange rate moves since it fails to prioritize the most recent data points, instead giving them the same weight as those at the beginning of the time period are given. 

Since the WMAs and EMAs emphasize the most recent data points, they exhibit reduced lag. They tend to be more responsive to recent exchange rate level changes than an SMA with the same time period parameter. 

Most technical forex traders will use one or more MAs to smooth exchange rate charts and identify trends. Some might even use crossovers to generate trading signals. 

Keep in mind that the more time periods used to compute the MA, the slower it will react to market changes. A shorter MA with fewer calculation periods will typically lag less and respond faster to changes in exchange rate levels. This can make it more useful for indicating the direction of short-term trends. 

The most basic MA trading strategy involves using one MA plotted over a currency pair’s exchange rate chart to generate a trading signal when they cross over. Many traders instead prefer to use a short-term and a long-term MA to generate crossover trading signals since the shorter-term MA smoothes out sharp exchange rate swings that can cause false trade signals.

When using a MA crossover method, a buy signal is generated when the exchange rate level or the shorter-term moving average crosses upward over the longer-term moving average. Similarly, a sell signal is generated when the level of the exchange rate or shorter-term MA crosses down below that of the longer-term MA. Traders usually use different colors to help them visually distinguish the short- and long-term MA lines. 

Bollinger Bands

The Bollinger Bands indicator is based on an SMA and two outer lines or bands. These bands are computed by using a specific number of standard deviations from the central SMA. 

Since historical volatility can be calculated as the standard deviation of an asset’s returns over a fixed time period, this means the Bolliginer Bands indicator incorporates a volatility component that can inform traders about the degree of risk present in the market. 

An advantage of using the Bollinger Bands is that they adjust to differing levels of market volatility as it varies over time. Bollinger Bands tend to widen during more volatile time frames and narrow during periods of more stable markets.

The Bollinger Bands indicator is generally plotted around the exchange rate on a chart, although some traders do prefer to place it in the indicator box below the chart. Traders who use the former method sometimes use the two outer Bollinger Bands lines as theoretical upper and lower guides that should contain most exchange rate swings. 

In addition, when an exchange rate movement begins on one outer line of the band, it often extends to the opposite side of the band. This can be useful for traders setting exchange rate objectives.

A strategy that uses Bollinger Bands could involve selling when the market exceeds the upper line of the band and buying back when the market dips below that line. 

You can further refine this strategy by only allowing trades that follow the direction of the prevailing trend. For example, the Bollinger Bands might indicate a short position when a short-term moving average slopes downward but the exchange rate is trading above the upper band. Similarly, taking a long position might be signaled if the MA is sloping upwards when the market trades below the lower band of the Bollinger Bands indicator. 

MACD Indicator

Developed by Gerald Appel, the Moving Average Convergence Divergence (MACD) indicator is widely considered one of the most useful and reliable momentum oscillator indicators for traders. 

Although the MACD is a lagging indicator computed from historical exchange rate data, it can also be used to predict when a market might soon change direction. The MACD gives technical traders a single indicator that lets them determine:

• if a trend exists 
• the strength of the trend 
• in which direction the trend is heading
• if the trend is overdone and may soon reverse direction

Computing the MACD indicator involves calculating the difference between two MAs of an exchange rate. It is usually plotted as a histogram of the difference observed for each time period in an indicator box situated below the exchange rate chart.

The MACD can be applied to charts of any time frame. It does not have absolute limits on its values, and it oscillates above and below the zero line. 

Analysts who use the MACD will typically calculate its value by subtracting a 26-period EMA’s average value from a 12-period EMA and plot a histogram of these differences. This gives you the classic MACD indicator as recommended by Appel. Additionally, a trigger line consisting of a nine-period SMA of the MACD is also calculated. 

The SMA line is graphed over the MACD histogram and generates signals that can help traders identify possible trading opportunities. Traders sometimes vary the lengths of the moving averages to adjust to more optimum levels for different currency pairs and often use another indicator in conjunction with the MACD for confirmation. 

Traders using the MACD to generate signals will typically look for crossovers between the SMA line and the histogram. Another type of MACD crossover occurs when the indicator crosses the zero line, moving either above or below it. If the indicator falls below the zero line, then it could generate a sell signal. Conversely, when the indicator exceeds the zero line, it could indicate a buying opportunity. 

MACD divergence occurs when the MACD level diverges from the exchange rate level.  Such situations can be bullish or bearish depending on how the MACD diverges. 

A bullish divergence occurs when the MACD makes higher lows despite the exchange rate making lower lows in a downtrend. This indicates the market is ripe for a reversal to the upside. 

A bearish divergence occurs when the MACD makes a lower high despite the exchange rate making a higher high in an uptrend. This generates a signal that the market might be ready to reverse its uptrend and trade lower. 

Divergence provides a good clue that the market may be close to a reversal point, which gains added importance when the MACD is in overbought or oversold territory. The indicator’s presence in extreme territory can also be used as a signal of overbought or oversold market conditions that can arise just before a market’s directional reversal.

To use the indicator for overbought or oversold conditions, look for situations when the shorter-term MACD moving average diverges significantly from the longer-term moving average. This indicates an overextended market that is ripe for correction. 

Should You Use Leading or Lagging Indicators?

Making the right choice regarding whether to incorporate leading and/or lagging technical indicators into your forex trading plan is an important decision that most strategic traders eventually have to make. 

In most cases, if you want to generate trading signals so that you can position appropriately to take advantage of future forex market moves, then you will want to select a leading indicator to provide those signals. Such indicators have well-established predictive value, and looking for situations where more than one of them gives a signal in the same direction can provide a confirmation mechanism that can help you filter out false signals. 

If you instead just want to analyze the present or past state of the forex market, then you can use lagging indicators. For example, you can use a lagging indicator like a moving average to help you discern if a trend has been in progress recently so that you can trade along with it. You might also want to determine how volatile the market has been so that you can manage your risk appropriately. 

Frequently Asked Questions