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A leading indicator is a type indicator that gives a signal before the new trend or reversal has started.

Leading indicators come in the form of oscillators.

An oscillator is defined as “an object (or data) that moves back and forth between two points”, like below.

 

oscillator

 

An oscillator will either give you a BUY or SELL signal, nothing in-between.

That means that when the oscillator is somewhere in between these two points there is no signal.

Oscillators work under the premise that as the momentum of trend begins to slow, fewer buyers (if an uptrend) or fewer sellers (if a downtrend) are willing to trade at the current price.

A change in momentum is often a signal that the current trend is weakening, which potentially signals that a new trend may be emerging.

 

Let’s have a look at some popular leading indicators, below.

 

 

The Parabolic SAR

The parabolic SAR (Stop And Reversal) is the most simplistic leading indicator.

It places ‘dots’ (also known as ‘points’) along the chart showing the movement of price. The parabolic SAR gives indications as to potential reversals in price movement.

 

parabolic SAR

 

When the dots are BELOW the candlestick, it is a BUY signal.

When the dots are ABOVE the candlestick, it is a SELL signal.

 

Typically, around 3 dots are required to confirm a potential reversal in price.

 

WHEN to use the parabolic SAR:
When the market is trending, where there is uptrends and downtrends.

WHEN NOT to use the parabolic SAR:
When the market is choppy, where the price movement is sideways.

 

 

The Stochastic Indicator

The stochastic indicator is a leading indicator that is used to predict the discontinuation of a trend. It works on the premise that;

  • During an uptrend, prices will remain equal to or above the previous periods closing price.
  • During a downtrend, prices will likely remain equal to or below the previous periods closing price.

 

The Stochastic indicator uses a scale to measure the degree of change between prices from one closing period to another.

In theory, it lets a trader know when the market is overbought or oversold

The stochastic indicator is measured from 0 to 100, where 0 is the highest oversold condition and 100 is the highest overbought condition.

 

stochastic graph

When the Stochastic lines areabove 80 (the red dotted line), then it means the market is overbought.

When the Stochastic lines arebelow 20 (the blue dotted line), then it means that the market isoversold.

 

You would aid a buying decision when the market is oversold, and aid a selling decision when the market is overbought.

 

WHEN to use the stochastic SAR:
When the market is choppy, where the price movement is sideways.

WHEN NOT to use the stochastic SAR:
When the market is trending, where there is uptrends and downtrends.

 

 

Relative Strength Index (RSI)

The RSI is similar in nature to the stochastic indicator. The RSI tracks overbought and oversold levels by measuring the velocity of price movements.

Like the stochastic indicator, the RSI is scaled from 0 to 100, where 100 is the highest overbought condition and 0 is the highest oversold condition.

 

overbought RSI

Typically, a reading of 30 or lower indicates oversold market conditions and an increase in the possibility of price strengthening (going up). This is because traders interpret that an oversold currency pair is an indication that the falling trend is likely to reverse, which means it’s an opportunity to buy.

 

Readings of 70 or higher indicates overbought market conditions and an increase in the possibility of price weakening (going down). This is because traders interpret that an overbought currency pair is an indication that the rising trend is likely to reverse, which means it’s an opportunity to sell.

 

The RSI is a very popular tool because it can also be used to confirm trend formations, helping to avoid trading a potential fakeout.

If you think a trend is forming, we would recommend to take a quick look at the RSI.

If you are looking to trade an UPTREND, then make sure the RSI is above 50.

If you are looking to trade a DOWNTREND, then make sure the RSI is below 50.

LESSON SUMMARY:

– A leading indicator is a type indicator that gives a signal before the new trend or reversal has started.

– An oscillator will either give you a BUY or SELL signal, nothing in-between.

–  The parabolic SAR (Stop And Reversal) is the most simplistic leading indicator that places dots above or below price, indicating potential reversals in trends.

– The stochastic indicator is a leading indicator that is used to predict the discontinuation of a trend. It is measured from 0 to 100, where 0 is the highest oversold condition and 100 is the highest overbought condition.

– The RSI is similar in nature to the stochastic indicator. The RSI tracks overbought and oversold levels by measuring the velocity of price movements. It is scaled from 0 to 100, where 100 is the highest overbought condition and 0 is the highest oversold condition.

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Back to: Free Forex Course > Step 7 - Technical Indicators
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