Leading Technical Indicators Explained: Has it ever intrigued you, as to why do we have so many Technical Indicator tools and why don’t all the indicators work at the same time and also in the same magnitude? The answer to this question is very simple. This is because not all technical indicators are the same and they can be classified as leading and lagging indicators.
There are certain indicators that try to pre-empt the likely move in the market. They use different ingredients and try to understand what could be the likely move in the prices of the underlying asset. These indicators are called Leading Indicators. On the other hand, there are certain indicators that try to understand the historical price movement and do a post mortem analysis. These are called Lagging Indicators.
Today, we will try to understand the best leading technical indicators that stock traders should definitely know. Keep reading.
What are Leading Technical Indicators?
Leading technical indicators are those Indicators that try to analyze the data received from past price movements and try to pre-empt or predict the future price movements. They allow traders to anticipate future price movements.
However, one needs to be careful while using leading indicators as they have a tendency to give out wrong information (for obvious reason as it is a prediction). Nonetheless, if the results turn out to be true then they can provide substantial returns.
Now, let us discuss the Best Leading Technical Indicators in detail that every stock trader should know:
1) RSI (Relative Strength Index)
The concept of RSI was developed by J.Wells Wilder and it is widely accepted as one of the Leading Momentum Indicators.
RSI is a very popular methodology amongst traders as it gives strong signals even during sideways and non-trending days. The value of RSI oscillates between 0 and 100. The default number of days while calculating RSI is 14 days.
- If the market starts to trade around 20 levels, then the falling momentum is expected to pause and we could be seeing a bullish reversal in the market.
- On the other hand, if the market trades around 80 levels on the RSI scale, the bullish momentum is expected to be halted and we could be seeing a bearish reversal in the market.
(Source: Zerodha Kite, RSI on Nifty)
Now, if we look at the image above, we see the RSI indicator being applied on the daily chart of Nifty. The RSI is applied on the bottom half of the chart.
As we see that the market is in a bearish momentum and the momentum looks like it wants to continue. But, if we look at the RSI scale, we see market trading below the 20 levels and which is where the falling momentum is expected to be halted (at least technically).
RSI indicator gave this momentum even as the market was still declining. But soon, we see selling momentum fizzling out. Once we see a higher low pattern formation on the chart, more buying seems to come in the market and fresh buying momentum follows soon.
If in the bullish market, we see the RSI scale touching 80 and starting to turn downwards, the bulls and long position are required to be careful as we could see a bearish reversal in the market.
One needs to be careful while overcommitting to these indicators, as the leading indicators are trying to predict the market and as we are aware that the predictions have the tendency to go wrong.
2) MACD (Moving Average Convergence Divergence)
MACD is an Acronym for Moving Average Convergence and Divergence. It is one of the most prominent and the most reliable form of leading technical indicator. The Concept of Bollinger Bands was developed by Gerald Appel in the ’70s.
As the name would suggest, MACD is a convergence and divergence of two moving averages. Therefore, convergence here is the movement of two moving averages towards each other. And divergence is the movement of two moving averages away from each other.
MACD is calculated by using a 12 day EMA and 26 EMA. The convergence or divergence is calculated by subtracting 26 EMA from 12 EMA. And a simple line graph is plotted from the calculated values and it is called a “MACD line”.
If the 12 EMA is higher than 26 EMA, it means that there is positive momentum in the market because the short-term EMA is a better indicator of current market strength. If the 12 EMA is below 26 EMA, that means that there is negative momentum in the market.
The difference between the two EMA is the MACD spread. When the share/stock is in momentum, then the spread increases. And the spread decreases when the momentum dwindles. We should look for buying opportunities when the spread is positive and vice-versa when the spread is negative.
(Source: Zerodha Kite, MACD on Reliance)
Now, the chart above is the daily chart of Reliance Industries and MACD has been used as a technical indicator. If we look at the chart above, a minimum of four trading opportunities has been spotted using the MACD indicator.
Starting from the left-hand side of the chart, in the first opportunity, when the MACD crosses from bottom to top, we get buying opportunity in the market. And the trade gives us a very substantial return of nearly 8-10% percent on the trade.
In the second opportunity, we get a selling chance in the market and even this trade gives us a return of more than 10% on the trade. A few more similar trade opportunities can be spotted in the market.
Again, importantly if we carefully look at the chart above, we see three MACD crossover trades in the market. A bearish trade when the MACD line goes below the 9 EMA line. And a buy trade when MACD crosses over 9 EMA on the upside.
Following are MACD interpretations:
- When the MACD line crosses the centerline (0 levels) from negative to positive territory, it means that there is a positive divergence. It’s a sign of bullish momentum
- When the MACD line crosses the centerline (0 levels) from positive to negative territory, it means that there is a negative divergence. It’s a sign of bearish momentum
- Now, a lot of you could be of the view that MACD is lagging and gives a signal after the move has happened. So, to improvise a simple 9 EMA is added. So whenever a crossover happens between MACD and 9 EMA, a trade opportunity is generated.
- The 12 EMA and 26 EMA are not hard and fast rules, one can change those parameters depending on one’s own trading style and aggressiveness.
Now from the discussion above, it can be seen that the best leading indicator gives us very profitable opportunities as we try to enter the trade before the actual move starts. But it does come with its own set of challenges because the leading indicators have a tendency to give false results.
That’s all for this post. We hope you have learned something new from our article on Leading Technical Indicators. Let us know your views in the comment section below. Happy Investing and Trading!!
Hitesh Singhi is an active derivative trader with over +10 years of experience of trading in Futures and Options in Indian Equity market and International energy products like Brent Crude, WTI Crude, RBOB, Gasoline etc. He has traded on BSE, NSE, ICE Exchange & NYMEX Exchange. By qualification, Hitesh has a graduate degree in Business Management and an MBA in Finance. Connect with Hitesh over Twitter here!