Many traders use the ROC Indicator to help identify changes in trend of a stock or the market. Known as the Rate of Change, the ROC Indicator measures how rapidly the price of a particular share (or other financial instrument) is moving.
Like other indicators the Rate of Change (ROC) indicator is useful in in identifying overbought and oversold conditions. It also is adapt at pointing out divergences from the trend, useful when trying to anticipate a trend reversal. When the indicator crosses over the signal line you have another buy or sell signal. It is best when used in conjunction with other indicators such as the MACD and the Slow Stochastic.
Rate of Change (ROC) Indicator Explained
The Rate of Change Indicator is easy to understand. If the price is rising rising quickly, a time will come when the price is considered overbought. When this occurs, the price is more likely to slow its move up and could easily turn down.
The ROC Indicator works to the down side as well. When the price is falling rapidly, a time will arrive when the price is considered over sold. An oversold condition indicates the price is more likely to slow its fall and turn up.
Normally, the indicator is plotted on a panel above or below the price chart. It is easy to set up on any stock charting system that includes the Rate of Change Indicator. The typical period is 12, though you can use other periods that might better suit the security being evaluated.
For example, if the price of a stock closes higher today than it did 12 days ago, the ROC will be above the equilibrium indicating that prices are rising for that particular security. Conversely, if the price in today's session closes lower than it did 12 days ago, the ROC will be below the equilibrium, indicating that prices are falling.
Like other trading and investing indicators, you can use it as an oversold and overbought indicator, for positive and negative divergence, and and as a crossover measure.
For those who wish to understand the ROC calculation please see the end of this article.
Overbought or Oversold Indicator
The ROC Indicator provides investors a way to identify an overbought and oversold condition. Unlike other indicators the exact level depends on the chart and the investors judgment. Rather, it is the signal the ROC gives after having reached an overbought or an over sold condition that matters.
Using the chart below, the over bought range begins at the 5% level. As shown the ROC can rise significantly above that level. The absolute level is not that important. A sell signal is given when the ROC turns down from an overbought level. This indicates that the trend of the underlying security is turning down. You should be ready to add down side protection or go short.
Again, on the chart below, an oversold condition occurs when the ROC is below the -5 level. A buy signal is given when the ROC turns up from an oversold condition. When you receive this signal, it is time to add to long positions.
The one year chart of the S&P 500 SPDR (SPY) offers some telling examples. The ROC Indicator fell to an extreme low in March 2009 before turning up. The move up by the indicator was a good buy signal. There have been several other good buy signals from the oversold condition.
The ROC has also gave several good sell signals when it turned down from an overbought condition. In January and again in February the ROC Indicator had risen to an overbought position and then turned down. In each case the signal was valid. In late 2009, the indicator gave several sell signals that also proved valid, though for a short time. This is indicative of an up trending market.
During the early stage of the rally that began in March 2009, the indicator gave several false sell signals as it rose to the overbought territory and then turned down. This is why it is good practice to always use other indicators to confirm the signals you receive from the ROC. MACD and Slow Stochastic are two that come to mind.
ROC Indicator Divergence
A divergence occurs when the ROC Indicator’s trend goes in the opposite direction of the price trend. Positive divergences should begin with a trough in the oversold area and negative divergences should begin with a peak at or above the overbought level.
The chart below show two divergences, one positive and one negative for the weekly SPY. The positive divergence started in November 2008, as the ROC turned up giving a buy signal. However, the price did not rally and it turned down again. The indicator then rebounded up before reaching the prior low in November 2008 forming positive divergence. In this case, the ROC Indicator's positive divergence was correct and the 2009 rally began.
Negative divergence takes place when the indicator reaches a high and then turns down, while the price either continues to rise or trade sideways. On the rebound of the ROC, it turns back down before reaching the prior high of the ROC indicator. The share price continues to trend up or sideways. There is an example of negative divergence in the chart below. In this case, we do not know the outcome as of the time of this writing.
The ROC divergence signal works in all time frames, though you should confirm the signal with other indicators and the underlying fundamentals.
ROC Indicator Crossover
A crossover is another feature of oscillators like the ROC Indicator. The zero centerline identifies the transition from a bear market to a bull when the Rate of Change rises up through zero. Should the ROC fall down through the zero line it gives a sell signal.
In the daily chart of the SPY there were a number of buy and sell signals given. When you look closely, these signals can end up with a small profit as the signal can be late in identifying the new trend. On the other hand, the indicator worked well when there was a longer up trend and the ROC did not fall below the centerline. In these cases, the ROC Indicator worked well and helped to keep investors on the right side of the trend.
As already mentioned, investors should use other indicators to confirm the signals provided by the ROC.
ROC Indicator Calculation
Assuming the period for the ROC calculation is "n" then the calculation is performed as follows:
ROC Indicator = ((Today's close - Close n periods ago)/(Close n periods ago))*100
"n periods" is the variable used to adjust the calculation. This can be any period used for the chart. Most chart systems start with a 10 period. You can and should try different periods to help find the period that works the best for the stock or security being evaluated.
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