Leading versus lagging indicators

Moving averages and the MACD are examples of trend following, or "lagging," indicators. [See Figure 30.] These indicators are superb when prices move in relatively long trends. They don't warn you of upcoming changes in prices, they simply tell you what prices are doing (i.e., rising or falling) so that you can invest accordingly. Trend following indicators have you buy and sell late and, in exchange for missing the early opportunities, they greatly reduce your risk by keeping you on the right side of the market.
Figure 30


As shown in Figure 31, trend following indicators do not work well in sideways markets.


Another class of indicators are "leading" indicators. These indicators help you profit by predicting what prices will do next. Leading indicators provide greater rewards at the expense of increased risk. They perform best in sideways, "trading" markets.
Leading indicators typically work by measuring how "overbought" or "oversold" a security is. This is done with the assumption that a security that is "oversold" will bounce back. [See Figure 32.]



What type of indicators you use, leading or lagging, is a matter of personal preference. It has been my experience that most investors (including me) are better at following trends than predicting them. Thus, I personally prefer trend following indicators. However, I have met many successful investors who prefer leading indicators.