What Is a Lagging Indicator in the Stock Market?
Whether you’re investing or day trading, the extent to which you analyze opportunities plays a significant role in your returns. This is true whether you focus on stocks, exchange-traded funds (ETFs), forex, cryptocurrency, or any other asset class.
You can use technical analysis to analyze price movements and determine the best times to enter or exit a position in financial markets. There are two types of indicators to look for in a price chart: lagging indicators and leading indicators.
Lagging indicators are more popular among long-term investors because they’re used to identify long-term trends, rather than to try to predict the immediate future. But what exactly are lagging indicators and what do they tell you?
What Is a Lagging Indicator in the Stock Market?
A lagging indicator is a type of technical indicator investors and traders use to define and confirm long-term trends. They are called lagging indicators because they use historical data to help you determine the direction and veracity of a trend, whether a stock is overbought or oversold, and the best time to enter and exit positions.
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Technical lagging indicators make it easy to see patterns in a stock’s price action. Investors and traders use lagging indicators to define trends and confirm trading signals given by other indicators.
For example, say a stock you’re considering buying has dropped in price and now appears to be undervalued. You can use a lagging indicator to see when the downward trend is starting to slow, suggesting that a reversal in the trend is on the horizon.
How Lagging Indicators Work
Lagging indicators define market trends by assessing historical stock price data. Every indicator is different, but the ideas behind them are similar.
Typically, these indicators use the closing prices of stocks over a period of time to make it easier to see and understand trends by weeding out the minute-by-minute volatility of the stock market.
For example, a lagging indicator may average closing prices over a 30-day period to create a more stable line on a chart that clearly shows the direction of the stock’s trend over that period.
Some lagging indicators are known as oscillators, meaning they track a price or signal line (such as a moving average) as it moves between two extremes. Typically, when the signal line or price nears the highest extreme in the oscillator, the stock is said to be overbought — perhaps a great time to sell. On the other hand, when the price or signal line is near the low end of the spectrum, the indicator produces a sign to buy the stock because it’s likely oversold.
Types of Lagging Indicators
There are several types of lagging indicators in the market. Some, like moving averages, use a single line plotted on a price chart. Oscillators use two extremes with a signal line in the middle to help you analyze price trends and identify significant movements.
Simple Moving Average (SMA)
A simple moving average (SMA) is the average price of an asset over a predetermined period of time.
The simple moving average makes it easy for you to weed out the noise caused by price volatility and see market trends in a smoother line to determine the direction and veracity of a trend.
For example, a 200-day SMA is the average price of an asset over the past 200 days plotted on a line graph. At the close of each trading session, the new closing price is added to the average and the oldest stock price is removed.
If you look at a 200-day SMA and the stock is clearly trending up, it’s a bullish signal that confirms a long-term upward trend. If the 200-day SMA is clearly trending down, it’s a bearish signal that confirms a long-term downward trend.
Moving Average Crossover
You can find moving average crossovers by plotting two separate moving averages with different time periods on the same price chart and looking for where they cross — hence the name.
When the short-term moving average crosses above the long-term moving average, it’s a bullish signal that you can use to confirm an upward trend. When the short-term moving average crosses below the long-term average, it’s a bearish signal, confirming a downtrend.
Moving Average Convergence Divergence (MACD)
The moving average convergence divergence indicator (MACD) is a momentum oscillator that uses a 26-day exponential moving average (EMA), a 12-day EMA, and a 9-day EMA to help you determine the direction and momentum of a trend.
You can use the oscillator to find several potential indicators of stock price movement. Look for crossovers and how the lines converge and diverge to learn more about the historical movement of the stock.
Relative Strength Index (RSI)
The relative strength index (RSI) is a momentum oscillator that moves up and down between two extreme values — zero and 100. Analysts use the average gains and average losses over a predetermined period of time to calculate the RSI.
A stock is typically considered oversold when it trades with an RSI of 30 or below and overbought when it trades with an RSI of 70 or above. Some investors may alter these figures to 20 and 80 to avoid a high occurrence of false positives.
Bollinger Bands are another momentum oscillator that uses historical data to help define a trend in the market. The indicator is used in conjunction with other technical indicators to determine if a stock is overbought or oversold.
Bollinger Bands are made up of three lines plotted on a stock chart based on an SMA and standard deviations from the SMA that produce the extremes of the oscillator.
Users often look for breakouts — points at which the price of an asset is higher or lower than the upper or lower bands. These signals suggest the price has moved abnormally far in one direction or the other and are usually followed by significant movement.
The stochastic oscillator compares a stock’s closing price to its high and low prices over a period of time, typically 14 days. The idea behind the oscillator is that a stock on a strong uptrend will close with a current price that’s near its highest high for the period. Conversely, a stock that’s trending down will close at prices near its lowest low for the period.
The stochastic oscillator reading ranges from zero to 100. Stocks with a reading of 20 or below are typically considered oversold and stocks with a reading of 80 or above are typically considered overbought.
Lagging vs. Leading Indicators
Lagging indicators and leading indicators are very different, although traders and investors typically use both types, and they’re typically based on the same data.
Lagging indicators use historical data to confirm long-term trends and inform you of overbought or oversold conditions. They’re simply an analysis of the past rather than an attempt to predict the future.
Leading indicators are the exact opposite. They use historical data, but not to define a trend but rather to attempt to indicate future price movements. They’re the crystal balls of the stock market.
Leading technical indicators are often used to find opportunities, but like any attempt at predicting the future, they’re not 100% accurate. These indicators use cues like volatility, momentum, and investor sentiment to produce signals, but they’re all too often false signals.
That’s why it’s important to use both types of indicators in conjunction with one another. When you use a leading indicator, it’s best to use a lagging indicator to confirm the findings.
For example, if a leading indicator signals a stock is heading for an upward reversal, you should consider double-checking the results using the stochastic oscillator or Bollinger Bands. If the lagging indicators show an oversold stock that’s losing downward momentum, your leading indicator may have hit the nail on the head.
On the other hand, if your lagging indicators point to continued downward momentum, you may have found a false signal.
Pros & Cons of Lagging Indicators
Lagging indicators are popular tools that investors and traders alike use, but there are always pros and cons to consider. Lagging indicators are no exception to the rule.
If something is popular in the stock market, it’s typically because it gives market participants a leg up. That’s true with lagging indicators. Some of the most exciting perks of using them include:
- Simplicity. Most lagging indicators are easy to use and understand. These tools are used to help you make sense of the volatility in the market and clearly define trends in the easiest way possible.
- No Calculations Necessary. Many lagging indicators are popular tools available at the click of a button on your favorite stock chart, so there’s no need to worry about learning intricate math to use them.
- More Accurate. Lagging indicators are typically more accurate than leading indicators because they make no attempt to predict the future. They simply outline the direction and momentum of price movement and leave the predictions up to the analysts who use them.
- A Long-Term Focus. Lagging indicators are historical in nature and centered around a long-term focus. Long-term investments and trades are statistically more successful than short-term trades, making long-term focused tools positive additions to an investor’s or trader’s toolbox.
These indicators may seem like a shiny new toy on Christmas morning, but as you use them, you’ll find they have their limitations. Some of the biggest drawbacks to lagging indicators include:
- Delayed Feedback. These indicators rely on historical data, so there’s a natural delay in the results you get from them. If you only use the lagging type of indicator, chances are you’ll miss opportunities associated with short-term price changes.
- Improper Use. These indicators are designed to confirm the momentum and direction of a trend, but they don’t predict the future. Beginners often use them as trading signals without confirming their results, leading to losses.
- History Doesn’t Always Repeat Itself. Lagging indicators are popular because there’s a general belief that history tends to repeat itself in the market. That may be the case most of the time, but not always. Past performance isn’t always an indication of future movement.
- Multiple Tools Necessary. These indicators aren’t designed to be used by themselves. They’re most accurate when multiple lagging and leading indicators are used together to confirm results.
Should You Use Lagging Indicators?
No matter what asset you’re interested in and whether you’re investing or trading, these historical indicators have the potential to expand your profitability. The market is a volatile place and it’s difficult to see opportunities through the minute-by-minute ups and downs in a stock chart.
Lagging indicators smooth the volatility so you can easily determine the direction of a trend. Most of these indicators also give you clues about the momentum of the trend. Strong momentum suggests the trend will likely continue, while weakening momentum points to a coming reversal. That’s valuable information no matter how you find opportunities in the market.
The key here is to know what these indicators do for you, what they don’t do, and use them as intended.
Never use a lagging indicator to predict the future or as a sole signal provider. These indicators are designed to improve your chances of profitability by confirming trends and signals from other indicators.
Also, don’t be shy about the number of indicators you use. There’s no shame in using a few different tools to ensure you don’t make your moves based on false signals.
Lagging Indicator FAQs
Lagging indicators are an interesting, yet complex topic. Anything having to do with historical financial data typically is. The best way to learn about something complex is to ask questions.
What Are the Best Lagging Indicators?
There are thousands of lagging indicators out there and the best one for me may not be the best for you. The indicators mentioned above are the most popular, but you should explore your options to see what fits best with your strategy. You may find your calling is tracking Fibonacci retracements or analyzing exponential moving averages (EMAs).
Why Are Lagging Indicators Important?
Lagging indicators are important because they make it easy to define trends — not just the direction of those trends, but the momentum too. This information can prove invaluable as you make your moves in the market.
Are There Lagging Economic Indicators?
Yes, there are several lagging economic indicators. Rather than tracking historical stock price action as their central data points, lagging economic indicators track fundamental economic data.
Investors often keep a close eye on indicators like gross domestic product (GDP), retail sales, unemployment rates, Federal Reserve interest rates, and even new home sales when making investment decisions.
All these lagging indicators use historical economic data to make it easy to determine the health of the economy.
Of course, the stock market moves up the most when economic conditions are positive. So you can use data from lagging economic indicators to make decisions like when and how to adjust your asset allocation or whether now is a good time to make a cyclical investment.
Most successful investors and traders use lagging indicators regardless of the investing or trading strategy they employ. These data-driven indicators are packed with information that can increase your profitability in the market.
Although these are important tools to use as you research opportunities, they’re not meant to be used in a vacuum. Combine them with leading indicators and fundamental analysis to get a complete picture of potential investments before making your moves.