Leading Indicators (part 4)
Thursday, April 26th, 2007 by daryIn the previous blog entry on leading indicators we discussed how the Stochastic indicator works well as a leading indicator when the stock is trending. In this blog entry we are going to discuss additional leading indicators and when they are best used.
Another example of a leading indicator is the RSI oscillator. Typically traders use the RSI with an interval period of 14 i.e. if the chart displayed is based on weekly interval periods, the RSI calculations are based on 14 weeks of historical price data. Using an interval period of 14, the RSI is typically considered overbought when greater than 70 and oversold when less than 30. If you look at the price movement of the QQQQs in the following price chart, each time the RSI fell below 30 and rebounded it is associated with a price low:
It should be noted that leading indicators can produce false buy and sell signals if the price movement is tightly range bound. For example, when General Electric was in a strong downward trend between May 2005 and September 2005, as illustrated by the red downward trending arrow on the General Electric price chart below, the Stochastic indicator provided a false long entry signal in June 2005.
This was repeated when General Electric was in a strong upward trend between July 2006 and January 2007, as illustrated by the red upward trending arrow on the General Electric price chart, as once again the Stochastic indicator provided a false long exit signal in October 2006 when the overall trend was still positive.
The main advantage that leading indicators have over lagging indicators is that they provide an early indication of a change in price movement, as a price pivot point is being formed, not afterwards when a trend has been established. It should be noted that when using a price pivot point to establish an entry point the overall trend should be considered.
There is greater risk associated with using leading indicators to establish when a long term trend is about to change as this can produce false entry or exit signals. A safer use of leading indicators is to establish entry and exit points for rolling a stock within a trend that is already established, i.e. repeatedly buying a stock when it is at support and selling at resistance.
Leading indicators are most effective when an equity is bouncing between support and resistance levels or trend lines within an established trend. Lagging indicators are better suited to establishing trends. For example the 100 day exponential moving average illustrated on the QQQQs price chart above, clearly indicates that the overall price movement of the QQQQs is upwards; however if you were to base your entry and exit investment timing on each time the price rose above or fell below the moving average, you would always be late entering and exiting your position.
You can use TimeToTrade to notify you when price and commonly used leading and lagging technical analysis charting conditions are met. For example, you can use TimeToTrade to notify you when the Stochastic and RSI indicators fall below or rise above threshold values, or for example to notify you when the price rises above its moving or exponential moving average.
