The rate-of-change (ROC) indicator, which is also referred to as simply momentum, is a pure momentum oscillator. It reflects the change in price from one user-defined period to the next. Traders use ROC in numerous ways, primarily looking for signals that include centerline crossovers, divergences and overbought/oversold readings. The indicator can be displayed in either point changes or percentage changes.
When the ROC indicator displays the price change in points, it simply subtracts the price “x time periods ago” from the current price. When ROC displays the price change as a percentage, it divides the price change by the price from “x time periods ago,” as such:
ROC = [(Close - Close n periods ago) / (Close n periods ago)] * 100
It is a well-recognized phenomenon that security prices surge ahead and retract in a cyclical wave-like pattern. This cyclical action is the result of the changing expectations as bulls and bears struggle to control prices. The ROC indicator shows the wave-like motion in an oscillator format by displaying the degree that prices have changed, measured in points or percentage, over time.
As prices increase, the ROC oscillator rises; as prices fall, it falls. The greater the price change, the greater the change in the ROC oscillator. The ROC value turns positive as a price advance accelerates. It dives deeper into negative territory as a decline accelerates.
The time period during which the ROC is calculated may range from one period (for example, one day) to 200 periods or longer. The shorter the range, the more volatile the movements in the ROC value. The most popular time period durations are 12- and 25-day ranges for short- and intermediate-term periods. These time periods were popularized by the well known technical analysts Gerald Appel and Fred Hitschler.
The 12-day ROC is an excellent short- to intermediate-term overbought/oversold indicator. Here is what it tells the analyst:
- The higher the ROC value, the more overbought the security;
- The lower the ROC value, the more likely a rally.
However, as with all overbought/oversold indicators, it is prudent to wait for the market to begin to correct (that is, price turns in the opposite direction of the predominant trend) 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 and could signal that a position with the trend may be profitable.
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 (see “Ups and downs,” below).
The chart shows the 12-day ROC oscillator for the Dow Jones Industrial Average stock index from August 2015 until February 2016. As shown, the ROC touched a low of -10 on Aug. 25. The Dow made a bottom of 15,370 on Aug. 24 and rallied. Again ROC made a low of -9 on Jan. 15, while the Dow made another short-term bottom and rallied again.
As we can see in the chart, not all high or low readings were accompanied by tops or bottoms in the stock index. This is why it’s important to wait for signals in price itself to confirm the overbought and oversold readings before considering positions in the market.
Price can move three ways: Up, down or sideways. Momentum oscillators are ideally suited for sideways price action with regular fluctuations between two extremes. This makes it easier to identify profitable extremes and forecast turning points. Markets want to trend, and the longer a market chops around in a range, the better opportunity for a breakout in either direction.
However, the overall trend does not have to be exactly sideways. Security prices also can fluctuate when trending, moving up and down within a channel. 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 ROC indicator can be used to identify periods when the percentage change nears a level that foreshadowed a turning point in the past.
Here are some possible rules for
- Go long when the ROC value crosses below the oversold level and then rises back above it.
- Go short when the ROC value crosses above the overbought level and then drops back below it.
You might set -10% as the oversold boundary and +10% as the overbought boundary. Movements below or above these levels indicate that prices are at a short-term extreme. Oversold readings serve as an alert to the trader that it’s time to prepare for a possible turning point. Prices are oversold, for example, but have yet to actually turn. Remember, a security can become oversold and remain oversold as the decline continues.
As shown in “Signaling trades” (below) a -10% oversold reading was hit in Apple (AAPL) on Aug. 25, 2015, when the stock made a low of $91.10. The stock opened gap down and started covering the gap as the ROC also declined to -10% and started moving up. Aggressive longs could have been placed with a stop loss set at the low for a 3% to 5% move target.
The stock made a high of $113.00 on Sept. 11, 2015.
The traditional interpretation of divergence is that if the price is going in one direction and the momentum indicator is moving in the opposite direction, the price momentum is dropping and the trend is likely ending.
A lower peak in the ROC value occurring in conjunction with higher highs in the security is called negative or bearish divergence; typically, this is a sell signal. Go short on a bearish divergence with the first peak above the overbought level.
A higher peak in the ROC value occurring in conjunction with lower lows in the security is called positive or bullish divergence; typically, it’s a buy signal. Go long on bullish divergences where the first trough is below the oversold level.
“Two directions” (below) shows this taking place in Caterpillar (CAT). The stock was making higher highs during the Oct. 22 to Nov. 4, 2015 period, but the ROC oscillator was making lower highs, which is a clear negative divergence. In this case, the stock dropped from 72 to 58 by Feb. 16.
Time to change
The ROC oscillator measures the speed at which prices are changing. An upward surge in the ROC value reflects a sharp price advance. A downward plunge indicates a steep price decline. Traders can look for bullish and bearish divergences for signals to trade based on the ROC.
It is important to remember that prices are constantly increasing as long as the ROC remains positive. Positive readings may be less than before, but a positive ROC still reflects a price increase, not a price decline. Like all technical indicators, the ROC oscillator should be used in conjunction with other technical analysis tools.