Leading and Lagging Indicators   

Leading & Lagging Stocks Noticeable in Big Market Gains

by Ian Harvey
February 17, 2020

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The market’s leading and lagging indicators help to identify stocks that might be poised to outperform during the near term!

During the type of days where the indexes are rising, the bulls become excited and look to their portfolios for assurance.

However, there's nothing more demoralizing than being heavily exposed to a stock (or group of stocks) that does not participate in such a strong rally.

Therefore, traders use indicators to identify market patterns and trends. Most of these indicators fall into two categories: leading and lagging.

Comparison of Participating to Non-participating Stocks

Why did some stocks participate in this market surge whilst other did not?

Is this a signal that non-participating stocks are weak, and should be sold -- or is the opposite true?

However, the answer lies within the many recent studies conducted, showing that stocks have a strong tendency to mean-revert, where equities that are weak over a certain time frame will generally tend to outperform going forward.

Mean-reversion Philosophy

The underlying principle of mean-reversion trading is that when stocks rapidly move away from their mean price they will revert back to that mean in the short term. If a stock falls rapidly in price then it is likely to rally in the short term and if a stock rises rapidly in price then it is likely to fall in the short term.

Leading and Lagging Indicators

By organizing the stocks into three groups based on their relative strength to the market an observance of leading and lagging stocks is unveiled. The stocks that underperformed (relative strength of less than 0.97) are listed as "laggards," and those that outperformed (relative strength above 1.04) are the "leaders."

The lagging indicators are the ones which go after the price pattern of the stock, security, or commodity -- follows an event.

In other words, a lagging indicator is a tool that provides delayed feedback, which means it gives a signal once the price movement has already passed or is in progress. These are used by traders to confirm the price trend before they enter a trade.

The information is then created from a past assortment of data and therefore is effective in denoting if a new trend is currently developing or whether or not the stocks are inside trading ranges. Also, the lagging indicators don’t succeed in predicting pullbacks or rallies in the future.

On the other hand, the leading indicators will be able to predict what may happen later on -- signaling future events.

In other words, by using a leading indicator - which is a tool designed to anticipate the future direction of a market - provides a trader a means to predict market movements ahead of time.

Crashes, pullbacks, or price rallies are often determined since they calculate the movement of the prices momentum. These tools can also define prices which have gone way too high or too low thereby providing the words overbought and oversold.

Strategy Involved for Leading and Lagging Indicators

When deciding on a strategy to enter a trade, it is essential to realize that about half of the trading in a stock is due to the fundamentals of the company and the other half due to the conditions of the market. The market overreacts for a variety of factors; "hot money" jumps on news, investors will dump at a sign of adverse developments, money managers do not like holding losing positions portfolios. These fluctuations, having nothing to do with the fundamental value of the stock, are opportunities.

Studies show that over the long term, the market is efficient. Prices will reflect the fair value of the stock based on all available information. Basically, all of the information that is out there will be accounted for and factored into the price of the stock. That is the basis of the efficient market hypothesis.

But, over the short term, the market is very inefficient.

Leading and Lagging Indicators and Effects on the Options Market

As the market enters new earnings seasons, tension will build and this could lead to some out-sized returns for option buyers. Over the past years, stocks that were laggards in the two weeks ahead of their earnings period, tended to outperform by more during their earnings than stocks that performed well in this prior period.

By buying calls on the under-performers ahead of earnings can sometimes be more profitable than buying calls on stocks that outperformed in the two weeks ahead of the earnings period.

This is defined as the earnings event period starting five days before the results are announced.

In Summary

The most obvious difference is that leading indicators predict market movements, while lagging indicators confirm trends that are already taking place. Both leading and lagging indicators have their own advantages and drawbacks, so it’s crucial to familiarize yourself with how each works and decide which fits in with your strategy.

Leading indicators react to prices quickly, which can be great for short-term traders, but makes them prone to giving out false signals – these happen when a signal indicates it’s time to enter the market, but the trend promptly reverses. Conversely, lagging indicators are far slower to react, which means that traders would have more accuracy but could be late in entering the market.

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Best of Trading,
Ian Harvey
Director of Stock Options Made Easy


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