Last Updated on 24 September, 2020 by Samuelsson
What is ROC – Rate of Change Indicator?
Rate of Change Indicator (ROC) is an indicator used in technical analysis measuring the percentage change in price of a financial asset between two periods of time. The periods are the most recent price and the price a defined time of periods ago. ROC is a momentum indicator used to spot on charts divergences, overbought or oversold conditions and confirm the trend or the trend change.
How Is ROC Calculated?
The calculation of ROC is very easy, requiring only two inputs of data. The closing price today, and the closing price n periods ago. N periods can be anything, from 5 to 14 periods to capture a whole trading week or almost 3 weeks if n periods relate to days. N periods can be also weeks or months, but days are the most common use. The formula to calculate ROC is the following:
ROC = [(Close – Close n periods ago) / (Close n periods ago)] * 100
A practical example shows that if the close today is 100 and the close 14 days ago was 85, then ROC= [(100 – 85) / (85)] * 100 or 17.64. This means price increased by 17.64% over the 14-day period. As seen the ROC calculation is very simple and is not time consuming. The ROC is an oscillator with its price moving above and below the zero line, having no boundaries as in a strong uptrend the price of ROC will show readings that increase over time. As the value of ROC is depending on the actual price of the financial assets, it is not uncommon its readings to continue expanding to higher levels within a specific time period. Both negative and positive readings of the ROC oscillator can be expected. Positive readings of ROC indicate an uptrend, while negative readings a downtrend.
How ROC Can Be Used By Traders and Investors
There are several uses of ROC in technical analysis and trading:
- Spot divergences
- Identify overbought or oversold conditions
- Be an early warning of trend change with centerline crossovers
- Confirm continuation of a trend
Using two charts as examples traders or investors can realize the value of ROC as a momentum-based indicator.
The first chart is the daily chart of Apple Inc (AAPL) stock showing a negative divergence between the price of the stock and the ROC indicator. Using trendlines there was a strong divergence as the price of AAPL stock moved higher recently, but the price of ROC indicator at the same time was moving lower. A strong decline for the price of the AAPL stock followed confirming this negative divergence. ROC indicator worked well in this case. This does not mean however that it is a 100% foolproof indicator used for trading purposes.
The next chart is the daily chart of Twitter Inc (TWTR) stock showing a positive divergence. After forming a double bottom near the price level of $30 the price of TWTR stock moved slightly lower, while the price of ROC indicator was already increasing and a nice rally for the stock price soon followed confirming again this early divergence. As seen very often but not always ROC indicator is a powerful early signal either to buy or sell a stock.
Overbought and Oversold ROC Conditions
As mentioned earlier above ROC show readings at extreme values, as it has no boundaries. In a very strong uptrend of a specific stock or in earnings surprises the ROC oscillator could show readings outside the usual range within a specific time period. These overbought or oversold extremes should be monitored as they could indicate either a consolidation, or even a trend reversal for a stock. In contrast with other oscillators that have a defined range, the ROC oscillator extreme values are highly subjective. One trader may consider an extreme value to be too far extended, while at the same time another trader may continue to believe there is still room for the ROC readings to move to higher levels.
An Early Warning of Trend Changes With Centerline ROC Crossovers
A ROC reading above zero in most cases is associated with a bullish bias. On the contrary, a ROC reading below zero indicates a bearish bias or a downtrend. If there is a crossover of the ROC reading above or below the zero line, this could be an early signal that an imminent trend change could soon follow. If the ROC readings for a long time period for example has been above the zero line, a crossover above the zero line may indicate that the downtrend may have paused, a bottom has been formed, and higher price levels could be expected for the underlying financial asset.
Confirm Continuation of a trend
The slope of the ROC readings and its actual readings can confirm the recent trend and its strength. An extreme slope of the ROC shows excessive buying or selling pressure and may not be sustainable over time. This does not mean that a reversal is likely to happen, but a price retracement could follow. In this context traders could wait to buy the stock or sell it at lower or higher price levels. A smooth slope for the ROC oscillator is more valid for the continuation of the current trend, indicating a balanced supply and demand for the underlying stock or other financial assets.
Pros and Cons of the Rate of Change Indicator (ROC)
Pros of ROC Indicator:
- The ROC indicator can work well in trending market conditions, confirming the most recent trend, either up or down.
- It is a momentum-based indicator and can reveal important information about the strength of the most recent trend. But it is highly recommended to be used not as a standalone technical indicator, it is better to take into consideration some other indicators as well.
- The ROC indicator can identify overbought or oversold conditions.
- The ROC indicator is also a powerful technical tool to spot divergences.
Cons of ROC Indicator:
- The ROC indicator can provide false signals. It is important to note that when the reading of ROC indicator stays for a significant time near the zero line, a consolidation phase may follow, buying or selling may be too early trying to catch a significant price move of the underlying financial asset.
- Equal weight is given in the calculation of ROC indicator to the most recent price and the price of periods chosen. Some indicators such as exponential moving averages give more weight on recent price, which is more important.
- Several signals may be bad if the ROC indicator is not used the proper way. Price action is the base of technical analysis, while the ROC indicator is simply a lagging indicator.
A Real-Life Example
The above chart is the weekly chart of Twilio Inc (TWLO) stock. We mentioned that the ROC indicator can highlight divergences and possible trend changes. This is an example of the ROC indicator giving false signals for a very long time period. There are at least 3 peaks for the ROC reading, and all of them would have given wrong trading signals to investors. There are no technical indicators that work 100%.
The ROC indicator can also be used as a part of a simple trading system. It can be both a momentum-based indicator and a trend following indicator. For traders who prefer simple trading strategies, buying a stock if the ROC is rising makes both sense and is easy to monitor frequently. When the ROC indicator slope starts to fluctuate significantly this increased volatility can be an early alert for the trader or investor to tighten the stop-loss and even close any open positions.
The ROC indicator in periods of high volatility based on economic news or other fundamental news may not be so effective compared to the previous examples. This does not mean that it is not a good momentum-based indicator. The Rate of Change Indicator (ROC) is simple and easy to use measuring a very basic yet very important thing, the speed at which price changes occur. In the context of combing the ROC indicator with other methods of technical analysis, there are increased odds of successful trades over time.