Leading and Lagging Indicators

By following my "Index Trading" post on July 10, 2010 where I wrote "In summary I would say that I see number of factors that favor further up-move." we basically saw positive trading at the beginning of this week.

Then in my "Increase in Volume" post on July 13, 2010 I stated "At this moment the majority indicators continue to be bullish and, personally, I would expect to see positive and sideway trading during this week." and then in my "Nasdaq 100" post I mentioned "Yet taking into account increase in volume I may expect a slow down of the current recovery, and at leas a side-way trading - then we may see how it develops.". As it happened, we had 2 trading sessions of side way trading (July 14-15, 2010) and then strong decline on the last day of the week (July 16, 2010).

Now, the main question is whether the stock market (Nasdaq 100, S&P 500 and DJI) indexes will continue their drop, or there could be other scenario. Below, I tried to summaries some points that on my opinion may help in understanding possibilities of further trend development.

1. The Friday's drop down was very strong. The Dow Jones Industrials dropped on that day by 2.8%. The stronger DJI bearish trading last time was seen on June 29, 2010 and on June 4, 2010.
2. The indexes were only two trading sessions in side-way trading at the top before that decline (June 14-15).
3. During that decline we had very strong oversold advance/decline readings (in both issues and in volume)
4. During that decline we had strong output of the bearish volume (very high trading volume).

All four points above would recommend that this is could be logical healthy drop down to release some overbought pressure collected over the 8 positive trading sessions in a row on the Nasdaq 100 ( 7 positive sessions on DJI) and now, even we could have some further decline the odds could be good that we may see indexes back to their June 13-15 high levels.

The Bearish points are:

1. Majority technical indicators show bearish signals.
2. Volatility is increasing.

Leading indicators (volume and advance decline based technical studies) signal that the stock market (indexes) is predisposed to bounce up. However, most of the lagging technical studies (price based indicators) are bearish.  The high volatility is very important factor on my point. Because of high volatility we may see strong and sudden changes in a trend when most of the technical indicators (due to a lag) would generate signals when it's too late to open/close position. High volatility also suggest that the market is still weak and even if we see bounce up, if the volatility does not go down, there will be a possibility of developing of another down-move.

Overall, by summarizing all of the above, I would say that if I would be in short, I would think about closing short position or at least about setting a stop-loss to protect profit. I would not rush into a long trade (majority of indicators are still bearish) and I would monitor index charts closely for possibility of changes in the sentiment toward bullish trading.

Leading and Lagging Techical Indicators

Short Description: some answer on subject of what technical studies to use.

The technical indicators (studies) could be divided into several categories by the type of data they are based on: price based indicators, volume based indicators, advance/decline (or Breadth) indicators and combined indicators that are based on price and volume or price and advance/decline data. The other way to classify technical indicators is to classify them by the way they are used in technical analysis.

There are three basic ways to use indicators in the analysis and a category that would cover each particular indicator depends on what this indicator indicates or what type of signals it generates:

1. Leading Technical Indicators – indicators that signal possible trend reversal in the future;

2. Lagging Technical Indicators – indicators that follow changes in the trend which also called trend-following indicators;

3. Informational Technical Indicators – indicators that do not predict nor follow a trend, but describe market, index or traded security. The examples of such indicators could be ATR, VIX and other studies are used to measure volatility, ADX that is used to measure strength of a trend and define sideway markets, etc.

In many sources you may find that the main role of technical analysis is to generate buy and sell signals. Based on the classification above I would say that this definition of technical analysis purpose is somewhat misleading since the informational studies which are used in analysis do not generate "Buy/Sell" signals. I would rather say that the purpose of the technical analysis is to analyze the current market or stock condition in relation to the past. After that, the result of technical analysis could be used in a trading system to generate "Buy/Sell" signals and most likely a good trading system would use technical studies from each category defined above.

A good trading system would use the leading indicators to signal a possible change in a trend. However, there is no 100% guarantee that after a leading indicator generates a signal you will see a reversal. As an example, a volume surge during the price decline signals possible change in supply/demand balance and following reversal move up. However, it does not tell you when it could happen: in 5 min, in an hour, in a day, etc. At the same time there could be situation when signals generated by leading indicators could be ignored – in our example of volume – the small volume surges could be ignored if stock or market is in strong up or down trend.

Now, we came to the lagging (trend following) indicators. They could be used alone, however, by itself lagging indicators could generate fake signals or generate signal when it is too late to open or close a trade. The best way to use them is in combination with leading indicators: a leading indicator generates signal about possible trend reversal and then lagging indicator confirms this reversal. In this trading strategy a trade is opened only after a lagging indicator confirms previously generated signal by a leading indicator. Al other situations when only one of the indicators signals a reversal are simply ignored. A trading system based on this strategy allows applying more sensitive setting to lagging indicators (by alone it would be considered very risky) and open a trade closer to reversals.

The last group of technical studies delivers important information used in technical analysis to adjust leading and lagging indicators setting as well as modify trading strategy in accordance to the current market condition. For instance ATR (Average True Range) is used in technical analysis to measure market (when applied to indexes) and security (when applied to a single security) volatility. It is usual that in highly volatile market we may witness rapid and strong changes in a trend. In this case a trader could be willing to adjust his/her indicators to be more sensitive (lower bar period setting, go to lower timeframe…). On the other hand in quiet market it could be good idea to set bigger lag (increase bar period setting, move to higher timeframe) and make indicators to generate signals with some delay. The ADX (Average Directional Index) could be another example of using informational indicators. ADX by itself does not generate signals at all -it tells only whether market/stock is in strong trend, weak trend or flat market. Based on the results of ADX analysis a trader may adjust a trading strategy and for instance trade only “Buy” short-term signals in longer-term strong up trend and trade only "Sell" signals in longer-term strong down-trend, and trade both signals during weak or sideway trend.

As you may see there are different technical indicators and as a rule professional analysts always use combination of them. Analysis of one indicator, sooner or later, may lead to the disappointment that this indicator is bad. My opinion is that there are no bad technical indicators - there could be only an incorrect way they are used. If you are looking for technical indicator that would generate stable positive return all the time I would recommend you do not waste your time but spend it rather on learning several technical studies that would help you to see the complete picture and not just some part of it.