Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
Leading and Lagging Indicators, Achieving a Balance (Part 1)
01/21/2008 12:00 am EST
How would you like a trading methodology that gives you predefined entry levels, reasonably tight stops, and pre calculated profit objectives as soon as you enter the move? We're not through. Add to that a very high percentage of winning trades. This is not only the promise but it can also be the reality of properly mixing high quality leading and lagging indicators in an overall trading methodology.
Almost every technical indicator is a lagging indicator. Moving averages, MACD, the RSI, Stochastics, you name it, we're talking lagging indicators. First there's a move in price, then sometime later in the game, the indicator signals buy or sell. That's why lagging indicators are called lagging indicators. They lag behind market action. They give signals after the fact. Leading indicators, on the other hand, tell us ahead of time where the market is likely to find support or where the market is likely to find resistance. Most traders who have attempted to use leading indicators have looked toward some form of overbought or oversold oscillator. Most oscillators, however, are in the camp of coincident or lagging indicators. They may tell us when a market is at a resistant point or when a market is at a support level, but typically they do not give us useful information ahead of time.
Traders rightfully view the use of leading indicators as a dangerous enterprise because few traders understand how to place a true leading indicator in the proper context to achieve the desired results. The trick is to achieve the proper balance by mixing leading and lagging indicators across time frames. If we can accomplish this objective, we can come up with a trading approach that is far superior to using either of the two exclusively.
Let's look at the problem more closely. Traders, being rational human beings, prefer lagging indicators because they want the comfort level of seeing a market already in a move prior to their entry. Unfortunately, this kind of comfort comes at a price. Once the lagging indicator is firmly established in a given direction, everyone else sees the move and everyone else is getting in at about the same time. Those who provide the necessary liquidity to fill the orders of the lagging indicator traders need to make their profit, so now we're ready for a retracement. This retracement is typically to the area where the lagging indicator players put their stop. The net result is the lagging indicator trader may be right on market direction, but is all too often stopped out before the market goes the way he knew it would all along.
So how do we overcome this situation? Buy pre calculated dips in an overall uptrend. Sell pre calculated rallies in an overall downtrend. We determine the location of such dips and rallies with high quality leading indicators. Stay tuned for part 2 tomorrow.
by Joe DiNapoli of FibNodes.com
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