What are leading and lagging indicators?

Leading and lagging indicators are tools for assessing the strength of an economy or financial market. Simply put, leading indicators change ahead of an economic cycle or market trend. In contrast, lagging indicators are based on analysis of historical events, providing a reference to historical data about the operation of a specific market or economy.

In other words, leading indicators provide predictive signals (before an event or trend occurs), while lagging indicators generate guidance signals based on trends that have already occurred. These two types of indicators are widely used by investors and traders who use technical analysis (TA) and play an important role in stock, forex and cryptocurrency trading.  

In financial markets, the history of technical analysis indicators can be traced back to the early 20th century. The ideas behind these indicators stem from the Dow Theory, which emerged between 1902 and 1929. The core of the Dow Theory is the assertion that price movements are not random and therefore market movements can be predicted through analysis of previous market behavior.

In addition to this, leading and lagging indicators can be used to chart economic trends. Therefore, they are not always related to technical analysis and market prices, but also to other economic variables and indices.

How leading and lagging indicators work

Leading indicators

As mentioned before, leading indicators can predict future trends. Therefore, these indicators can be used to predict potential recessions or recoveries. For example, regarding stock market performance, retail sales or building permits.

Therefore, leading indicators tend to transcend economic cycles and are often suitable for short- and medium-term cycle analysis. For example, building permits are considered a leading economic indicator. Its emergence could indicate increased demand for construction workers and investment in the real estate market in the future.

Lagging Indicators

In contrast to leading indicators, lagging indicators are used to identify existing trends. And these trends may not be immediately apparent. Therefore, this indicator lags behind the economic cycle.  

Typically, lagging indicators are often used in long-term analysis, based on historical economic performance or previous price data. In other words, lagging indicators create signals based on market trends and financial transactions that have already been initiated or established.

Synchronization indicator

Although not very popular in the cryptocurrency field, the synchronization indicator is the third Three types of indicators are still worth mentioning. This indicator is somewhere between the other two types of indicators. It operates in near real-time, providing analytical information on current economic conditions.

For example, synchronized metrics can be generated by measuring the hours worked by a group of employees or the productivity of a specific industry, such as manufacturing or mining.

It is worth noting that the definitions of leading, lagging and concurrent indicators are not clearly defined. Some indicators are further divided into several different categories based on different methods and scenarios. This is especially common with economic indicators such as gross domestic product (GDP).

GDP is generally considered a lagging indicator because it is calculated based on historical data. However, in some cases it may reflect near real-time economic changes and may be viewed as a synchronized indicator.

Use cases in technical analysis

As mentioned above, economic indicators are also financial markets a part of. Many traders and chart analysis experts deploy technical analysis tools that are either leading indicators or lagging indicators.

Essentially, leading technical indicators provide some kind of predictive information. They are usually based on market prices and trading volumes. This means they may reflect market movements that may occur in the near future. However, like other indicators, leading indicators are not always accurate.

Leading indicators used in technical analysis include the Relative Strength Index (RSI) and the Stochastic Relative Strength Index (RSI). In a sense, even a candlestick can be considered a leading indicator due to the movement it creates. In fact, these patterns can provide a reference for future market events.

Lagging indicators in technical analysis, on the other hand, are based on historical data and allow traders to understand events that have already occurred. It can also come in handy when spotting new market trends. For example, when an uptrend ends and the price falls below the moving average, this may indicate that a downtrend has begun.

In some cases, both types of indicators may appear simultaneously in a single charting system. For example, the Ichimoku chart consists of leading and lagging indicators.

When used in technical analysis, leading indicators and lagging indicators have their own pros and cons. Leading indicators offer traders the best opportunity when it comes to predicting future trends. The problem, however, is that leading indicators often produce misleading signals.

At the same time, lagging indicators tend to be more reliable because their definitions come from exact historical market data. The significant disadvantage of lagging indicators is that they are less responsive to market movements. In some cases, the timing of a signal for a trader to open a profitable position may be relatively late, resulting in low potential returns.

Role in macroeconomics

In addition to being able to evaluate prices, these two indicators In addition to market trends, it can also be used to analyze macroeconomic trends. Economic indicators are different from those used in technical analysis, but can still be broadly divided into leading and lagging.

In addition to the previously cited examples, other major economic indicators include retail sales, house prices and manufacturing activity levels. Typically, such indicators are thought to drive future economic activity, or at least provide predictable information.  

There are two other typical examples of lagging indicators in macroeconomics, including the unemployment rate and the inflation rate. There are also GDP and CPI. These two data are often used to compare the development levels of different countries, or to evaluate a country's growth compared with a few years ago or decades ago.

Summary

Whether it is applied to technical analysis or macroeconomics, leading indicators and lagging indicators play a very important role in many types of financial research. They help interpret different types of data, often combining multiple concepts within a single investment vehicle.

So, these indicators can ultimately predict future trends or confirm trends that have already occurred. In addition, they are also very useful when evaluating a country's economic performance, either by comparing it with other countries or by comparing it with data from previous years.