Leading Technical Indicators
Relative strength index (RSI)
The relative strength index (RSI) is a momentum indicator, which traders can use to identify whether a market is overbought or oversold. When the RSI gives a signal, it is believed that the market will reverse – this provides a leading sign that a trader should enter or exit a position.
The RSI is an oscillator, so it is shown on a scale from zero to 100. If the RSI is above 70, the market would often be thought of as overbought and appear as red on the chart (below). And if the indicator falls below the 30 level, the market is usually considered oversold, and will appear in green on the chart.
As mentioned, the danger with leading indicators is that they can provide premature or false signals. With the RSI, it is possible that the market will sustain overbought or oversold conditions for long periods of time, without reversing. This makes it important to have suitable risk management measures in place, such as stops and limits.
Another popular example of a leading indicator is the stochastic oscillator, which is used to compare recent closing prices to the previous trading range.
The stochastic is based on the idea that market momentum changes direction much faster than volume or price, so it can be used to predict the direction of market movements. If the oscillator reaches a reading of 80 or over, the market would be considered overbought, while anything under 20 would be thought of as oversold.
The oscillator is shown as two lines on the chart, the %K (the black line on the chart below) and the %D (the red dotted line below). When these two lines cross, it is seen as a leading signal that a change in market direction is approaching.
During volatile market conditions, the stochastic is prone to false signals. To prevent this impacting your trades, you could use the stochastic in conjunction with other indicators or use it as a filter for your trades rather than a trigger. This would mean entering the market once the trend is confirmed, as you would with a lagging indicator.
Elliot Wave Theory
The Williams percent range, more commonly known as the Williams %R, is very similar to the stochastic oscillator. The main difference being that it works on a negative scale – so it ranges between zero and -100, and uses -20 and -80 as the overbought and oversold signals respectively.
So, on the below chart, the green line below -80 indicates that the price is likely to rise. While the red line above -20 indicates the price is likely to fall.
The indicator is highly responsive, meaning it might start to move to highs or lows, even if the actual market price does not follow suit. As the Williams %R is leading, these signals can be premature and less reliable than other entry signals, which is why some traders prefer to use -10 and -90 as more extreme price signals.
On-balance volume (OBV)
On-balance volume (OBV) is another leading momentum-based indicator. It looks at volume to enable traders to make predictions about the market price – OBV is largely used in shares trading, as volume is well documented by stock exchanges.
Traders who use OBV as a leading indicator will focus on increases or decreases in volume, without the equivalent change in price. This is believed to be an indication that the price will increase or decrease imminently.
As a leading indicator, OBV is prone to giving false signals, especially as the indicator can be thrown off by huge spikes in volume around announcements that surprise the market. Although volume changes, this is not always indicative of a trend and can cause traders to open positions prematurely.
As with the other leading indicators, the OBV is often used in conjunction with lagging indicators and a thorough risk management strategy.