Last Updated on 17 November, 2020 by Samuelsson
As a trader, you have access to countless indicators that perform all types of calculations to provide clues about the various traits and behavior of the market. The RSI indicator is one of the most widely used trading indicators and gives us a better sense of the momentum in the market, as well as oversold and overbought readings. However, while knowing what the indicator is measuring could be said to be the most important thing, many traders are also concerned with whether it’s a lagging or a leading indicator.
So, is RSI a lagging or a leading indicator? Yes, by the definition that a leading indicator precedes a price move, RSI is a leading indicator. In a lot of cases, RSI will turn around before the market, performing a so-called divergence, which warns about the potential reversion of the market.
In this article we are going to have a closer look at the RSI and how it acts as a leading indicator, what a leading indicator actually means, and the different applications of leading versus lagging indicators.
Lagging Indicators and Leading Indicators in Trading
Traders often divide trading indicators into two main categories, namely lagging and leading indicators.
In short, the difference between the two is that leading indicators are supposed to react before the actual price move, while lagging indicators instead react after the price move. For instance, if the market is falling and turns oversold, a lagging indicator will, in theory, be falling together with the market, and rise first after the market has turned up. A leading indicator, on the other hand, should precede the price reversal in the form of, in this case, a bullish signal.
While leading indicators should precede the moves of the market, it’s important to recognize that most indicators should not be used to predict price moves on their own. At best, they can provide hints and help us identify profitable scenarios.
How Is RSI A Leading Indicator?
RSI is a leading indicator when considering mainly two scenarios.
The first is the classical approach of applying the RSI, which revolves around finding bottoms and tops in the market. Once the RSI closes below 30 or even lower, it is believed that the market has become oversold and is about to revert soon. As such, the RSI gives us a hint that the market has gone too far, and leads us into assuming that a turnaround might be imminent!
The image below shows an example of such a setup.
The second approach is to watch for divergences. A divergence is when the RSI indicator starts to move in the opposite direction of the price, showing us that the momentum is waning. In classical technical analysis, divergences tell us that a reversal might be coming soon, even though they aren’t used for exact timing purposes.
The image below shows an example of a divergence between the RSI and the price. The RSI starts making new highs, while the price is continuing down. In other words, we have a so-called bullish divergence.
Leading Vs Lagging Indicators – Which is best?
While many people make the lagging traits of some indicators seem like a disadvantage, that is not completely true. Many times, the historical behavior of a market, and thus its price patterns, are of high significance when it comes to finding opportunities when the market is likely to shoot up. In fact, the whole premise of a large part of technical analysis as a whole is that price indeed contains information relevant for forecasting where prices are headed.
The moving average, which only is an average of the x-last bars, is a perfect example of this. Despite deriving all its data and just showing what has happened in the past, it’s a beloved indicator which is used successfully by nearly all traders.
However, while this holds true, some traders do acknowledge the issue of giving the same weight to all closing prices which are part of the average calculation. The rationale goes that price moves become less and less relevant the longer ago they occurred. To resolve this issue, there have been several attempts to change the formula of the moving average to make it more adaptive, out of which a couple variations have gained a lot of popularity!
If you are interested in learning more about moving averages, we recommend that you take a closer look at our definitive guide to moving averages!
Some traders believe that lagging indicators cannot make up a trading strategy on their own, but must be coupled with some leading indicators or signals to produce profitable results. In that sense, the lagging indicator becomes a sort of filter, which is used to identify when the overall market conditions are favorable for the type of entry signal we are looking at.
This indeed holds true in many cases. For example, the moving average is often used as a regime filter to decide when the market is in a bullish or bearish trend. The performance of various setups usually varies a lot depending on the current market sentiment, which often is correlated with the bearish or bullish state of the market. As such, moving averages can be used to turn on or off a strategy, in order to only trade during the most favorable times.
RSI is a leading indicator in the sense that it often warns about the reversal of the market before it has actually happened. Most of the time, this occurs through a so-called divergence, or in the form of oversold or overbought readings.
We recommend that you have a closer look at our definitive guide to RSI if you want to learn more! There we share a lot more about the indicator, and how many traders use it to profit in the markets!