Trading using PRICE RATE-OF-CHANGE

Introduction

The Rate-of-Change (ROC) 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. As a momentum oscillator, ROC signals include centreline crossovers, divergences and overbought-oversold readings.

The Price Rate-of-Change (“ROC”) indicator displays the difference between the current price and the price x-time periods ago. The difference can be displayed in either points or as a percentage

Calculation

When the Rate-of-Change displays the price change in points, it subtracts the price x-time

periods ago from today’s price. When the Rate-of-Change displays the price change as a percentage, it divides the price change by price x-time period’s ago:

ROC = [(Close – Close n periods ago) / (Close n periods ago)] * 100

Interpretation

It is a well recognized phenomenon that security prices surge ahead and retract in a cyclical wave-like motion. This cyclical action is the result of the changing expectations as bulls and bears struggle to control prices.

The ROC displays the wave-like motion in an oscillator format by measuring the amount that prices have changed over a given time period.

As prices increase, the ROC rises; as prices fall, the ROC falls. The greater the change in prices, the greater the change in the ROC. ROC expands into positive territory as an advance accelerates. ROC dives deeper into negative territory as a decline accelerates.

The time period used to calculate the ROC may range from 1-day (which results in a volatile chart showing the daily price change) to 200-days (or longer). The most popular time periods are the 12- and 25-day ROC for short to intermediate-term trading. These time periods were popularized by Gerald Appel and Fred Hitschler.

The 12-day ROC is an excellent short- to intermediate-term overbought/oversold indicator.

  • The higher the ROC, the more overbought the security;
  • The lower the ROC, the more likely a rally.

However, as with all overbought/over-sold indicators, it is prudent to wait for the market to begin to correct (i.e., turn up or down) before placing your trade. A market that appears overbought may remain overbought for some time. In fact, extremely overbought/oversold readings usually imply a continuation of the current trend.

The 12-day ROC tends to be very cyclical, oscillating back and forth in a fairly regular cycle. Often, price changes can be anticipated by studying the previous cycles of the ROC and relating the previous cycles to the current market.

Trading Signals

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.

Rule to Trade

  • Go long when ROC crosses to below the oversold level and then rises back above it.
  • Go short when ROC crosses to above the overbought level and then falls back below it.

-10% was set as the oversold boundary and +10% as Overbought boundary. Movements below/above  this level indicated that prices were at a short-term extreme. Oversold readings serve as an alert to be ready for a turning point. Prices are oversold, but have yet to actually turn. Remember, a security can become oversold and remain oversold as the decline continues.

Divergence

The traditional interpretation is that if price is going in one direction and the momentum indicator in the opposite direction, divergence is occurring and suggests that the trend is ending.

A lower peak in the Rate Of Change of Price (ROC) against higher highs in the security called negative divergence and typically it’s a Sell signal. Go short on a bearish divergence – with the first peak above the overbought level.

A higher peak in the Rate Of Change of Price (ROC) against lower lows in the security  called positive divergence and typically it’s a Buy signal.Go long on bullish divergences – where the first trough is below the oversold level.

Below Video we have discussed in Detail with Example on Nifty and Bank Nifty,

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. Traders can look for bullish and bearish divergences, for trading based on ROC. 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 indicator, the Rate-of-Change oscillator should be used in conjunction with other aspects of technical analysis.

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