It's been a ground breaking week for the Australian sharemarket with the 200 day moving average being broken and the market smashing past the 4000 mark.
Why is this significant? Because it means that the longer-term bear trend which has been in place since November 2007 has come to an end.
Here I'll explain the significance and the importance of understanding leading and lagging indicators, like the 200 day moving average.
When it comes to technical analysis, there are lagging or leading indicators. Understanding which category the indicators fall into can help technical analysts understand strengths and weaknesses in your trading tool box, but they can have disadvantages as well.
A leading indicator gives a buy or sell signal before the new trend has started.
Now before you get too excited thinking "here's the crystal ball that I’ve been looking for my whole trading life", one of the problems with leading indicators is that it gives lots of fake signals.
So while you do get a head start on the trend, you also get lots of false starts.
On the other hand, you have lagging indicators. The 200 day moving average is a lagging indicator. So what's a lagging indictor?
These indicators catch a trend after it has started so it’s a little slow.
The plus is that it is more reliable.
The problem is often you miss the very beginning of the trend which may mean you miss a significant chunk of profit.
Leading indicators in the form of oscillators such as RSI (Relative Strength Indices), Parabolic SAR and stochastic, give a buy or sell signal before the new trend has started.
If you use any of these, remember that you may get a head start on the trend but you need to back up your signals to make sure it’s not a fake.
What about lagging momentum indicators? Some examples are moving averages and the MACD. These indicators tend to be reliable but are slow. So keep in mind that you have accuracy but you may be sacrificing a chunk of profit in return for the accuracy.
In the end, no one indicator is the holy grail of profits. In actual fact, you can get a clearer picture of what is happening by combining indicators.
Try using both leading and lagging indictors to get an edge in terms of accuracy and profitability.
In summary, the 200 day moving average has been broken which is positive but remember that this indicator is slow. If you have a look at a leading indicator like RSI, then the market is starting to look overbought so be careful because the leading indicator is sending an alarm that it could soon be time for consolidation before the market moves higher.
Remember, leading indicators have the advantage in being able to spot a trend before it starts but is prone to many misleading signals. Lagging indictors are more reliable but tend to be a bit slow. I like to use both to get a clearer picture of a developing trend and then confirmation of a trend.
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Happy trading!
Julia Lee Equities Analyst Bell Direct
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