Indicators are a type of tool used by traders to gauge movements in price levels or the price directions of an asset. Indicators apply various mathematical calculations to past data in order to measure the movement in price levels to help traders make investment choices. As such, indicators fulfill three major functions: to alert, to confirm, and to predict. They can alert investors to significant shifts, such as a waning momentum or a positive divergence, that need to be monitored for investment opportunities; they can confirm the results of other technical analysis tools to bolster their validity; and they can also predict the direction of prices helping investors decide how and when to place their trades.
Lagging and Leading Indicators
An indicator can either be leading or lagging, depending on the kind of information it analyses and the results it provides.
Leading Indicators predict how prices might react in the future. These indicators measure how overbought or oversold a stock is and work best for short-term predictions in active trading markets. Although leading indicators can provide high rewards, they also carry high risks.
Lagging Indicators map the recorded movements and trends of a price as they occur. Thus lagging indicators do not provide warnings about future price changes, but rather inform investors of mature trends which provide a reduced-risk environment for buying and selling. These indicators better serve investors interested in following price movements for long-term trades.
Technical Indicators vs. Market Indicators
Indicators can also be distinguished into two different types depending on the scope of their analysis: technical indicators and market indicators.
Technical Indicators, also collectively called ‘technicals’, provide data points generated through the application of mathematical formulas to the price data of an asset. Price data consist in the various points of a price (open, high, low, close) over a certain period of time, and each indicator uses specific combinations of these to derive its points. The creation of these data points allows meaningful comparisons to be made between past and present data. Technical indicators focus solely on charts and numbers, and do not analyse any fundamental business indicators, such as earnings, revenue, or profit margins. Thus technical indicators provide analysis for short-term price movements and benefit mostly active traders looking for short-term opportunities. Long-term investors, however, can also use these indicators to identify good entry or exit points for a trade.
Market Indicators also provide data points derived from a formula, but they do so for major financial indices, rather than isolated assets. Market indicators are essentially a series of technical indicators applied to the price data of a wider part of the market and as such they provide a more general outlook on the market’s direction. The wider scope of market indicators help traders gauge whether the broader market is moving in favor of an individual asset they are monitoring for trade.