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All about Rate of Change Indicator to Help You Make More Money

The Rate-of-Change indicator, which is also referred to as simply Momentum, is a pure momentum oscillator that measures the percent change in price from one period to the next. The ROC calculation compares the current price with the price “n” periods ago. The plot forms an oscillator that fluctuates above and below the zero line as the Rate-of-Change moves from positive to negative. As a momentum oscillator, ROC signals include centreline crossovers, divergences and overbought-oversold readings. Divergences fail to foreshadow reversals more often than not, so this article will forgo a detailed discussion on them. Even though centreline crossovers are prone to whipsaw, especially short-term, these crossovers can be used to identify the overall trend. Identifying overbought or oversold extremes comes naturally to the Rate-of-Change oscillator.

What is the Price Rate of Change Indicator?

The Price Rate of Change is a momentum-based technical indicator that measures the percentage change in price between the current price and the price a certain number of periods ago. The ROC indicator is plotted against zero, with the indicator moving upwards into positive territory if price changes are to the upside, and moving into negative territory if price changes are to the downside.

The indicator can be used to spot divergences, overbought and oversold conditions, and centerline crossovers.

How to Calculate the Price Rate of Change Indicator

The main step in calculating the ROC, is picking the "n" value. Short-term traders may choose a small n value, such as nine. Longer-term investors may choose a value such as 200. The n value is how many periods ago the current price is being compared to. Smaller values will see the ROC react more quickly to price changes, but that can also mean more false signals. A larger value means the ROC will react slower, but the signals could be more meaningful when they occur.

Select an n value. It can be anything such as 12, 25, or 200. Short-term trader traders typically use a smaller number while longer-term investors use a larger number.

Find the most recent period's closing price.

Find the period's close price from n periods ago.

Plug the prices from steps two and three into the ROC formula.

As each period ends, calculate the new ROC value.

As noted above, the Rate-of-Change indicator is momentum in its purest form. It measures the percentage increase or decrease in price over a given period of time. Think of it as the rise (price change) over the run (time). In general, prices are rising as long as the Rate-of-Change remains positive. Conversely, prices are falling when the Rate-of-Change is negative. ROC expands into positive territory as an advance accelerates. ROC dives deeper into negative territory as a decline accelerates. There is no upward boundary on the Rate-of-Change. The sky is the limit for an advance. There is, however, a downside limit. Securities can only decline 100%, which would be to zero. Even with these lopsided boundaries, Rate-of-Change produces identifiable extremes that signal overbought and oversold conditions.

What Does the Price Rate of Change Indicator Tell You?

Like most momentum oscillators, the ROC appears on a chart in a separate window below the price chart. The ROC is plotted against a zero line that differentiates positive and negative values. Positive values indicate upward buying pressure or momentum, while negative values below zero indicate selling pressure or downward momentum. Increasing values in either direction, positive or negative, indicate increasing momentum, and moves back toward zero indicate waning momentum.

Zero-line crossovers can be used to signal trend changes. Depending on the n value used these signals may come early in a trend change (small n value) or very late in a trend change (larger n value). The ROC is prone to whipsaws, especially around the zero line. Therefore, this signal is generally not used for trading purposes, but rather to simply alert traders that a trend change may be underway.

Overbought and oversold levels are also used. These levels are not fixed, but will vary by the asset being traded. Traders look to see what ROC values resulted in price reversals in the past. Often traders will find both positive and negative values where the price reversed with some regularity. When the ROC reaches these extreme readings again, traders will be on high alert and watch for the price to start reversing to confirm the ROC signal. With the ROC signal in place, and the price reversing to confirm the ROC signal, a trade may be considered.

ROC is also commonly used as a divergence indicator that signals a possible upcoming trend change. Divergence occurs when the price of a stock or another asset moves in one direction while its ROC moves in the opposite direction. For example, if a stock's price is rising over a period of time while the ROC is progressively moving lower, then the ROC is indicating bearish divergence from price, which signals a possible trend change to the downside. The same concept applies if the price is moving down and ROC is moving higher. This could signal a price move to the upside. Divergence is a notoriously poor timing signal since a divergence can last a long time and won't always result in a price reversal.

Trend Identification

Even though momentum oscillators are best suited for trading ranges or zigzag trends, they can also be used to define the overall direction of the underlying trend. There are approximately 250 trading days in a year. This can be broken down into 125 days per half year, 63 days per quarter and 21 days per month. A trend reversal starts with the shortest timeframe and gradually spreads to the other timeframes. In general, the long-term trend is up when both the 250-day and 125-day Rate-of-Change are positive. This means that prices are higher now than they were 12 and 6 months ago. Long positions taken 6 or 12 months ago would be profitable and buyers would be happy.

Overbought/Oversold Extremes

There are basically three price movements: up, down and sideways. Momentum oscillators are ideally suited for sideways price action with regular fluctuations. This makes it easier to identify extremes and forecast turning points. Security prices can also fluctuate when trending. For example, an uptrend consists of a series of higher highs and higher lows as prices zigzag higher. Pullbacks often occur at regular intervals based on the percentage move, time elapsed or both. A downtrend consists of lower lows and lower highs as prices zigzag lower. Counter trend advances retrace a portion of the prior decline and usually peak below the prior high. Peaks can occur at regular intervals based on the percentage move, time elapsed or both. The Rate-of-Change can be used to identify periods when the percentage change nears a level that foreshadowed a turning point in the past.

The Difference Between the Price Rate of Change and the Momentum Indicator

The two indicators are very similar and will yield similar results if using the same n value in each indicator. The primary difference is that the ROC divides the difference between the current price and price n periods ago by the price n periods ago. This makes it a percentage. Most calculations for the momentum indicator don't do this. Instead, the difference in price is simply multiplied by 100, or the current price is divided by the price n periods ago and then multiplied by 100. Both these indicators end up telling similar stories, although some traders may marginally prefer one over the other as they can provide slightly different readings.

Limitation of Using the Price Rate of Change Indicator

One potential problem with using the ROC indicator is that its calculation gives equal weight to the most recent price and the price from n periods ago, despite the fact that some technical analysts consider more recent price action to be of more importance in determining likely future price movement.

The indicator is also prone to whipsaws, especially around the zero line. This is because when the price consolidates the price changes shrink, moving the indicator toward zero. Such times can result in multiple false signals for trend trades, but does help confirm the price consolidation.

While the indicator can be used for divergence signals, the signals often occur far too early. When the ROC starts to diverge, the price can still run in the trending direction for some time. Therefore, divergence should not be acted on as a trade signal, but could be used to help confirm a trade if other reversal signals are present from other indicators and analysis methods.

Conclusion

The Rate-of-Change oscillator measures the speed at which prices are changing. An upward surge in the Rate-of-Change reflects a sharp price advance. A downward plunge indicates a steep price decline. Even though chartists can look for bullish and bearish divergences, these formations can be misleading because of sharp moves. Sustained advances often start with a big surge out of the gate. Subsequent advances are usually less sharp and this causes a bearish divergence to form in the Rate-of-Change oscillator. It is important to remember that prices are constantly increasing as long as the Rate-of-Change remains positive. Positive readings may be less than before, but a positive Rate-of-Change still reflects a price increase, not a price decline. Like all technical indicators, the Rate-of-Change oscillator should be used in conjunction with other aspects of technical analysis.

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