by Amanda Harvey
A lagging indicator is one of the main categories of technical indicators, and as the name implies it follows, or lags behind, the movement of prices. These indicators are also known as trend-following indicators, and as such, are more useful in a trending market than one which is trading sideways. They contrast with leading indicators which move in a certain direction ahead of the price action, and are also referred to as predictive indicators.
Technical indicators; both leading and lagging are obtained by applying a specific formula to data. This primarily consists of price information including various combinations of opening, closing, high and low prices, but may also incorporate volume and open interest.
One of the main purposes of indicators is to predict the probable future direction, strength, and turning point of a trend in price movement. Indicators are also a valuable tool for confirming signals that have been obtained from methods of technical analysis such as chart patterns. They may also provide important signals of an imminent breakout.
Uses of a Lagging Indicator
These trend-following indicators are most effective in identifying a trending market and staying with the trend. They can assist a trader in buying and selling during a trend in order to benefit from fluctuations in price. Signals are often generated by crossovers, which are points at which the line of the indicator crosses the line of the price. Divergences are also considered to be potentially worthwhile signals that a turning point may be imminent. Even though the indicator is moving behind the price, if it is moving in the opposite direction, this can suggest that the trend may be nearing an end, or a significant retracement.
Lagging indicators are also commonly used to provide confirmation of leading indicators. A trader may obtain signals by using a leading indicator, but then wait for the trend-following indicator to back it up before taking action. This suggests that the earlier signals from predictive indicators can act as an alert to a likely price move, but that the trade is often not made until a lagging indicator verifies the signal. “Ready and aim” may be interpreted from the leading indicator, but often it is wise to listen for the “fire” directive from the trend-following indicator.
Pros and Cons of Trend-Following Indicators
One of the biggest advantages of a lagging indicator is that it is far less prone than a leading indicator to give false signals. Leading indicators are often responsible for presenting misleading signs, and indicating what looks like a breakout but turns out to be a fakeout. Although, by using a trend-following indicator, a trader may be entering the game a little slow off the starting block, at least they will not be racing off in the wrong direction.
The fact that later signals mean a later entry is one of the main drawbacks of using trend-following indicators. This is why these indicators are best used in a strongly trending market, where there is more likely to be sufficient time to benefit from the prolonged movement, despite a delayed entry to the trade. In a market that is trading sideways, entering a short-term upward or downward movement as the result of a lagging signal will almost certainly mean entering too late.
With a trending market, however, a lagging signal can still provide plenty of opportunity to profit from the sustained movement. The indicator will also often provide further signals throughout the duration of the trend, allowing a trader to employ strategies, such as pyramid trading, to further benefit from the price movement.
Types of Lagging Indicators
One of the most popular types of trend-following indicators is Moving Averages. There are several kinds of Moving Averages, including Simple and Exponential Moving Averages. The Simple Moving Average can be calculated for various time frames, and uses a basic formula of the sum of the closing prices for each period in the time frame, divided by the number of periods in the time frame.
Another widely used trend-following indicator is the Moving Average Convergence Divergence (MACD). The MACD turns two trend-following moving averages into a momentum oscillator by subtracting the longer moving average from the shorter moving average.
Using a lagging indicator, such as Moving Averages or MACD, in a trending market can provide signals that a trend is continuing, and that there is opportunity to profit from this movement. Trend-following indicators also act as confirmation for signals generated by leading indicators; either of a continuation in price movement, or a likely change in direction. Although these trend-following indicators produce later signals than predictive indicators, they are also more likely to be accurate, and less prone to offer false signals.