What is a Leading Indicator?
A leading indicator is a technical indicator that uses past price data to forecast future price movements in the forex market. While there is no single indicator that forecasts future prices with 100 percent accuracy, traders will be able to view how price could unfold in the future and then apply further analysis to spot ideal entries into the market.
The opposite of a leading indicator is a lagging indicator and while they both make use of past data – lagging indicators use past data to project future price levels. Lagging indicators use past price data to confirm a recent change in price.
What are some examples of leading indicators?
The main, generally accepted, leading indicators include:
- Fibonacci Retracements
- Donchian channel
- key levels of support and resistance.
These will be presented and briefly discussed below.
In short, the Fibonacci retracement consists of numbers or ratios that are mathematically significant numbers that occur throughout nature and often in financial markets. The most important number or ratio is the 61.8% or .618 levels. In Forex trading, Fibonacci retracements can identify future possible levels of support and resistance.
The EUR/USD chart below shows maps out the direction that future prices may approach, if the 61.8% level is respected.
The 61.8% level was respected and the market resumed the broader downtrend and proceeded through the initial price target box to make a series of lower lows.
The Donchian channel calculates the highest high and the lowest low for the past X number of periods and presents this as an upper line and lower line. The upper and lower lines get updated as price continues to move.
The Donchian channel indicator is great for breakout or reversal trades in strong trending markets. For example, the USD/JPY chart below, shows how Donchian channels can help traders to trade a breakout
- Price starts out making lower lows and touches the lower bound of the channel before moving up.
- Price breaches the upper channel after a touch of the lower channel, providing the first bullish signal. A break of the upper channel after a touch on the lower channel is seen as the first signal for a long trade.
- The upper channel at point number 2 extends a horizontal line to the right, corresponding with the recent high. This acts as resistance and serves as further confirmation if price breaks above this level – which it does. Even though there is a large retracement, price does not breach the lower channel and eventually moves back up and past point 3.
A long signal is triggered when price rises off the lower channel (1) to breach the upper channel for the first time (2).
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The upper channel line extends to the right and provides a level of resistance to be tested or respected. With a long bias, traders will be looking for price to break this level, creating higher highs.
Even though there is a large retracement between point (2) and (3), price does not breach the lower channel and eventually moved back up to create a new high at point (3).
In an upward move like the one seen above, traders can utilise the lower channel as a manual trailing stop and adjust it upwards as the market advances.
Key Levels of Support and Resistance
Key levels of support and resistance occur when price approaches a particular level, multiple times, without breaking through it. This often results in price bouncing off two key levels in a range. Knowing where price has been before can assist traders to assess where the target should be placed.
In this example, price has approached resistance and turned, meaning the target should be placed at or just above support and a stop can be placed above resistance; while maintaining a positive risk to reward ratio. Price continued to move down and subsequently hit the target level.
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Benefits of leading indicators
Leading indicators are by no means a crystal ball, but they do allow the trader to visualize the various ranges where future price could trade. When having an idea of future price movements, traders are better placed to identify targets and stops with a greater accuracy.
Leading indicators provide the following benefits:
- Presents a clear directional bias
- Provides traders with a target level
- Provides traders with a stop loss level
- Leading indicators are not limited to just one indicator
- Leading indicators can act as a filter (i.e. trades that do not line up with the indicator can be disregarded)
Leading Indicators: A Summary
Leading indicators provide traders with indications of future price movements and by extension, clear stops and limits. Due to the fact that there is uncertainty when trading the financial markets, traders cannot afford to adopt a laid-back approach to risk management simply because a leading indicator provides a direction and level for future price movements. Remember that prudent risk management should be adopted at all times.
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- Markets can often surprise us, showing that there is still a lot to learn. Improve your knowledge by reading the three ways to become a better trader.
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