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How To Use Indicators That Lag The Price

|Includes: SPDR S&P 500 Trust ETF (SPY)

Using stock market indicators that lag the price

All price-based indicators lag the price, meaning that they issue trade/investment signals well behind the price movement. Let's look at the example of one of the most simple but wildly used Moving Average indicator (Simple Moving Average - SMA or Exponential Moving Average - EMA).

By definition, the indicator collects the price movements for a certain period in the past and calculates the average for that period. It is considered that the "buy" signal is issued when the Moving Average (yellow line) crosses up the price (black line). Correspondingly, the "sell" signal is issued when the Moving Average crosses down the price line. As seen on the chart above an investor that follows the signals issued by this indicator will always enter and ext the market too late. If we shorten the period of time the indicator is based on then its signals become more nimble (less lagging the price) but also less reliable. It will start producing many wrong signals that not following the price trend (making us prematurely exiting or entering the market).

Of course, more sophisticated indicators are available that work much better, but they all still lag the price movement to some extend. We will use in this discussion the "Critical Mass" indicator and the "buy"/"sell" signals it issues (see the chart below).

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This is a weekly chart that is based on the 12 year long price history, and it shows the buy/sell signals in both uptrending and downtrending markets. As seen above, with the exception when the market changes the major trend and becomes trendless, the recommended entry and exit signals produce quite profitable trades. Still, the indicator will issue a sell signals only when the price drops to the point when the indicator considers that there is some potential for the trend to change its direction (the decision is made by the price long term historical behavior). That means that some part of the gain should be gave up. Even more unsetting is the situation that happens during some market panic (when everyone rushes to an exit and when the price can easily drop 500 or more points for a single day).

There is no way avoiding this (unless one decides to exit when the price still rising) potentially losing all the benefits of the continuing long uptrend. However, there is a way to reduce the part of the gain we give up when exiting the long position following the "sell" signal issued by the indicator. The way to do this is to build a similar but daily chart with the signals that are based on a shorter duration (see below).

Again, as with any shorter-term indicators, we cannot use the signals on this chart for entering and exiting the market because they are less reliable. However, what can be done is to consider the signals on such shorter-term chart as a warning signals.

Then, when the short-term chart shows a new "sell" signal you continue staying invested but you reduce you holding by taking some portion of your investment of the market. You subsequently reinvest this portion back (at a lower price) if the conditions improved and a new "buy" signal is issued on the short-term chart. Note that no short-term "buy" signal can be issued during the down trending market. This approach substantially reduces your potential loss in such situation and improves your long-term performance.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.