Leading indicators are intended to track price movements, as their name suggests. The majority show a type of price momentum over a predetermined lookback period, or the number of periods that are utilized to compute the indicator. For instance, the last 20 days of price activity, or roughly a month, would be used in the computation of a 20-day stochastic oscillator. All previous price movements would be disregarded. The Commodity Channel Index (CCI), Momentum, Relative Strength Index (RSI), Stochastic Oscillator, and Williams %R are a few of the more often used leading indicators.
Momentum Oscillators
Momentum oscillators are a common type of leading indicator. In general, momentum quantifies how quickly the price of an asset changes. Price momentum rises as a security’s price does. The increase in momentum increases with the speed at which the security climbs (the larger the period-over-period price change). Momentum will slow as soon as this climb starts to slow. Momentum actually starts to drop from prior high levels when a security starts to trade flat. Declining momentum in the face of sideways trade, however, does not necessarily indicate a bear market. It merely indicates that momentum is gathering back to a level that is more median.
Momentum indicators quantify price fluctuations using a variety of formulas. An metric of momentum called the relative strength index (RSI) analyzes the average price change during rising and falling periods. From October until the end of November, RSI increased on the IBM chart. The stock rose from the upper 60s to the low 80s throughout this time. The RSI experienced a significant decline (blue lines) during the first part of December while the stock was trading sideways. The stock’s consolidation was healthy and rather typical. It would be anticipated that flat price movement would result in a drop in RSI (and momentum) from these high levels (around 70). If RSI were trading around 50 and the stock began to trade flat, the indicator would not be expected to decline. The green lines on the chart mark a period of sideways trading in the stock and in RSI. RSI started from a relatively median level, around 50. The subsequent flat price action in the stock also produced relatively flat price action in the indicator and it remains around 50.
Benefits and Drawbacks of Leading Indicators
There are many benefits to using leading indicators; most significantly, they allow for early signaling for entry and exit. More signals are produced and trading possibilities are made possible by leading indicators. Additionally, early indicators can serve as a warning against a possible strength or weakness. Because they generate more signals, leading indicators are best used in trading markets. These indicators can be used in trending markets, but usually with the major trend, not against it. In a market that is trending up, the best use is to help identify oversold conditions for buying opportunities. In a market that is trending down, leading indicators can help identify overbought situations for selling opportunities.
With early signals comes the prospect of higher returns and with higher returns comes the reality of greater risk. False signals and whipsaws are more likely when there are more signals and earlier signals. False signals will increase the potential for losses. Whipsaws can generate commissions that can eat away profits and test trading stamina.
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