Indicators are the cornerstones of technical analysis and play an important role in giving and confirming entry and exit signals in stock trading systems. There are quite a number of different types of indicators but they all fall into two categories:
- Leading Indicators are indicators that lead price movement. In other words, they indicate the probability of a trend reversal in advance. Most leading indicators measure price momentum over a fixed look-back period. Some of the popular leading indicators include the Commodity Channel Index (CCI), the Relative Strength Index (RSI), the Stochastic Oscillator and the Williams' %R (Wm%R).
- Lagging Indicators, which follow the price movement, are usually trend-following indicators, such as the Moving Averages (MAs) and Moving Average Convergence/Divergence (MACD). These indicators turn only after the price action has already turned and therefore lag price action.
Leading indicators are usually considered better than lagging indicators as they indicate a probable change in price action before it occurs. They thus offer an early warning of a change in market direction; however, their predictive nature does not necessarily increase their accuracy or validity.
Indicators also measure different aspects of the market action regardless of whether they are lagging and leading indicators. In addition, depending on how they are calculated, indicators can oscillate above and below a zero line. These are called oscillating indicators. Other types of indicators can be trend indicators, momentum indicators, volatility indicators, market strength indicators and cycle indicators. Different types of indicators can often contradict each other as some are better suited to trending markets while others are better suited to non-trending or ranging markets.
It is important that you understand an indicator, what it measures, how it is calculated, and how it reacts to price changes, before you use it. Once you know how an indicator works, and how it reacts to price changes, you would be better equipped at trading the technicals.