Traders often look for ways to measure the price momentum. The rate of change (ROC) is one of the most commonly used indicators for that. Let’s take a look at the indicator.
Often referred to as the momentum indicator, the rate of change (ROC) is a momentum-based technical indicator that compares the current price of a security to the price “n” period ago. It is plotted as an oscillator that moves above or below a zero-line as the momentum changes from positive to negative. Like other oscillators, the Rate of Change also has oversold/overbought levels that are adjusted according to the current market situation. At the end of the article we look at several ROC trading strategies.
What is the rate of change (ROC)?
The Rate of Change, which is also known as momentum, is a technical technical trading indicator that measures the momentum of price movements. It compares the current price of a security to the price “n” period ago. The indicator is plotted as an oscillator that moves above or below a zero-line as the momentum changes from positive to negative.
Like other oscillators, the Rate of Change also has oversold/overbought levels that are adjusted according to the current market situation. However, note that the market can remain at the oversold/overbought level for a prolonged period.
Here’s an example of how ROC looks on a chart:
ROC indicator example
The chart above shows the 15-day ROC, and as you can see, it oscillates pretty heavily, perhaps expected in volatile financial markets.
Nonetheless, the rate of change is an important concept in finance as it allows the market to be seen through the lens of momentum and other forms of trend.
For instance, a security with a positive rate of change or high momentum is likely to outperform the broader market in the short term (1-6 months), while one with lower momentum is likely to underperform the broader market in the short term and is seen as a bearish signal to investors. By comparing the momentum of various stocks with one another or with the broad market index, such as the S&P 500, we get the idea of relative momentum, which has been used to create profitable trading strategies over the years.
The rate of change is widely used to measure the average change in the price of a security over time. This is called the price rate of change which is derived by subtracting the price of a security at time A time from the price of a security at time B and then dividing that by the price at time A.
The rate of change can be particularly useful for options traders since they observe the relationship between the price rate of change of an option to a fractional change in the price of the underlying security (known as the options delta).
What is the formula? ROC indicator formula
Before calculating the rate of change, you have to pick the “n” value. Long-term traders would normally pick a longer period like 100 or 200 days, while short-term traders may opt for a closer period like 5, 10 or 20. The “n” value is the number of periods in the past you are comparing with the current price. As usual, smaller “n” values will result in a more volatile reading of the indicator which may also lead to too many signals, while larger values are less volatile and produced fewer signals to trade with.
The ROC formula is as follows:
Where:
= closing price
= closing price n periods ago
ROC = Rate of change
From the formula, you can see that the key factor in calculating the PROC is choosing the n period to use and also deciding the price type to use. On most trading platforms, the usual thing is to use the closing price — current closing price and closing price n periods ago.
The lookback period will depend on how far back you want to compare to the current price. While you can calculate the PROC by yourself using the above formula, your trading platform will do that for you and plot the values on the indicator window once the indicator is attached to the chart.
Who invented the rate of change?
The rate of change was developed by Tom Demark to measure the momentum of a security.
Why is PROC important for traders?
The PROC is important for traders because it shows how the market is moving and the momentum of the price movement. This is shown by its centerline crossovers, which traders use to track the changes in price momentum.
The indicator also helps traders monitor the price swings to know when the market is potentially overbought or oversold. It also produces divergence signals, which traders can use to anticipate price reversals. In essence, traders can use the PROC indicator to identify where the price is going and when to enter or exit the market.
What does a positive PROC indicate?
A positive PROC value indicates that the price momentum is positive — that is, the current price is higher than the price n periods ago. This means that the price is moving up. This appears on the indicator as a crossover above the centerline to the positive side.
When this happens, traders believe the price momentum is rising, so they look to go long in the market. However, when the positive value is too high compared to recent data, it may signal an overbought market, which means the market may be ready for a pullback or a full reversal. This is even more significant if subsequent higher prices fail to take the indicator higher, giving rise to a bearish divergence, which signals that a potential market reversal is around the corner.
What does the rate of change tell you?
The rate of change is plotted in a separate window below the price chart. It has a centerline (zero line) which is used to differentiate between positive and negative momentum. The indicator usually oscillates about the zero line, moving between the positive and negative territory.
A positive momentum usually indicates an increased buying pressure or rate of change, which tells you that the strength of the trend is accelerating. But a decreasing rate of change with an increase in price tells you that the uptrend will not be sustained. On the other hand, negative momentum below the zero line indicates downward momentum or selling pressure in a bearish market.
Most technical analysts consider centerline crossovers as an indication of a trend change. However, the centerline crossovers are prone to whipsaw, especially short-term. The “n” value has a great impact on how often the indicator crosses the centerline. Smaller values often result in more frequent crossovers or signal an early trend change. Larger values delay the crossover and give late signals.
ROC indicator strategy
The rate of change can also show extreme conditions in the market. Some analysts consider the market overbought when the ROC is far above the zero line (say +10) and oversold when the ROC is far below the zero line (say -10). However, these extremes are not bound to any value in particular as each security behaves differently from one another. To use this method, you have to study the indicator for each security to know the levels where the market had reversed in the past. This will give an idea of the overbought/oversold levels for that security. so
Furthermore, the rate of change can show divergence from the price action, which could signal a potential trend change. Divergence occurs when the price is moving in one direction while the indicator is moving opposite. A bearish divergence is when the price of a security is increasing while the rate of change is decelerating, which could indicate a trend reversal.
The same principle applies if the price of a security is declining with an increasing rate of change. This could indicate a trend reversal to the upside. However, divergence is not a reliable trading strategy as it could last for a prolonged time without any reversal taking place.
To wrap it up, if you want to use this indicator to create a trading system, make sure you combine it with other tools. Always backtest your system and optimize for robustness before putting your money on the line.
What does a negative PROC suggest?
A negative PROC value suggests that the price momentum is negative. This appears on the indicator as a crossover below the zero centerline to the negative side. It means the price is moving downwards. In other words, the current price is lower than the price n periods ago, which may signal an increasing momentum to the downside.
When the price momentum is increasing to the downside, traders look for opportunities to go short in the market. However, if the negative value is too low compared to recent data, it may signal an oversold market, which means that the market may be ready for a pullback or a full reversal to the upside. This is even more significant if subsequent lower prices fail to take the indicator lower, giving rise to a bullish divergence, which signals that a potential market reversal is around the corner.
How do traders use PROC in strategies?
Traders use the PROC in strategies in different ways. Some may use the centerline crossover to assess the momentum of the market so as to know when and how to enter and exit the market.
Others may use the overbought and oversold signals to identify the potential end of a pullback so they can trade in the direction of the trend. There are also traders who may add the divergence signals to their trading strategies to know when the market may be about to reverse so they can either enter or exit their trades. The way a trader uses the PROC depends on their trading strategies.
What is the difference between PROC and momentum?
The difference between PROC and momentum is that momentum is a property of price movement that defines the rate at which it moves, while PROC is a way to measure momentum.
There are other ways of estimating the price momentum, such as the RSI, stochastic, and even price action, but PROC is the most direct measure of the price momentum, as it directly measures the rate at which the price is rising or falling over time. Positive PROC indicates rising prices, while negative PROC indicates falling prices.
Using ROC in Trading
There are many ways to trade ROC in trading. We can mention:
- Breakouts
- Overbought and oversold situations
- Zero line crosses
- Divergences
This is the theory, at least. Below we’ll make some ROC backtests to see if these ROC methods work.
ROC indicator trading strategy (Rate of Change strategy)
Below you find a few ROC trading strategies (all backtested on S&P 500 (SPY)):
ROC trading strategy no 1: oversold – oscillating
Let’s start with the easiest backtest: oversold – a mean reversion strategy.
We like to start with a strategy optimization to see if there are any “sweet spots” and how robust the trading indicator is. The table below shows the following:
Trading Rules
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ROC indicator strategy (backtest)
The strategy performance metrics are pretty good. The best ROC indicator settings are 4 and 6 days (column 1 shows the number of days).
The equity curve of the best strategy (4 days) looks like this:
ROC indicator strategy (equity curve)
The strategy looks decent, but it suffers from some pretty sharp setbacks along the way.
ROC trading strategy no 2: breakouts
Let’s backtest a ROC indicator breakout strategy. We backtest the following rules and settings:
- We use a 4-day ROC based on the previous backtest done above (4-day ROC).
- When the ROC breaks above the N-day high of ROC (from 10 to 30 days), we go long at the close.
- We sell 20 days later at the close.
The strategy optimization looks like this:
ROC indicator strategy breakout (backtest)
The first column shows the lookback period for the breakout. The column called profit factor indicates that this is a poor trading strategy.
ROC trading strategy no 3: zero line crosses
Let’s go on to backtest a ROC strategy based on “zero line crossings”. We backtest the following rules and settings:
- We go long when the N-day ROC crosses BELOW zero.
- We sell at the close when the N-day ROC crosses ABOVE zero.
Our strategy optimization gave us the following backtesting results:
ROC indicator strategy zero line crossings (backtest)
The first column shows the different days in the lookback period (2-14 days), but the column called profit factor shows that the results are far from good.
When we backtested the opposite rules we got a lousy result (perhaps as expected).
ROC trading strategy no 4: divergences
We decided not to backtest any ROC divergence strategies because it’s difficult to quantify and to set the proper rules and settings.
Rate of Change Indicator trading strategies – Amibroker code
We have compiled Amibroker code for all the three strategies in this article. This code, plus code for at least 125 other different ideas and strategies, can be purchased here:
ROC vs RSI
ROC might seem similar to the RSI indicator both in the name and how they look on the charts, but the calculations are completely different. To start with, RSI has both upward and downward price change (ROC only one direction). However, both indicators measure the velocity of the moves.
ROC indicator trading strategy – ending remarks
Among the plenty trading indicators that exist, the Rate of Change indicator (ROC) is not among the best. Our backtested ROC trading strategies show that all of them fall short compared to the RSI, stochastic indicator, and Williams %R, to name the most obvious better trading indicators (please read our article called which is the best oscillating indicator). Thus, any ROC indicator trading strategy is most likely inferior to many others.
Can PROC help predict price reversals?
Yes, the PROC can help predict price reversals since it measures the momentum of price movements. First, when the momentum is declining, it could signal that a price reversal may be around the corner. Apart from that, extreme values of the indicator suggest an overbought or oversold condition, as the case may be, which could be an indication that the price may reverse soon — even if it’s just for a temporary pullback.
More importantly, though, the divergence signals are commonly used by traders to spot potential price reversals. A bullish divergence — when the price is making a lower low but the indicator is making a higher low or the other way around — signals a potential reversal to the upside. On the other hand, a bearish divergence — when the price is making a higher high but the indicator is making a lower high or the other way around — signals a potential reversal to the downside.
How does PROC compare to moving averages?
Compared to moving averages, the PROC is an indicator for spotting price swings based on the momentum of price movements, while moving averages are used to identify the trends. Traders use the PROC to gauge the momentum of the market and to identify overbought and oversold conditions in the market, as well as spot potential price reversals using divergence signals. On the other hand, they use moving averages to identify the trend and plan trend-following strategies.
What is the ideal PROC period to use?
The ideal PROC period to use would depend on the trader’s trading style and strategy, as well as the trading timeframe. If the trader is a scalper, they may use a shorter period for their PROC so that the indicator can be more sensitive to price changes. Similarly, a day trader would use a shorter-period PROC than a swing trader or a position trader. However, the best way to know the ideal PROC period to use is to backtest your strategy to find out the period that offers the best result.
How does PROC differ from the Relative Strength Index (RSI)?
The PROC differs from the Relative Strength Index (RSI) in that it directly measures the rate of change of price, unlike the RSI. Both indicators can be used to assess the price momentum but, while the RSI uses the relative number of up-periods and down-periods to estimate where the price momentum lies, the PROC directly measures the price momentum by measuring the rate at which the price changes occur over a given period.
In other words, the PROC is a direct measure of price momentum, while the RSI is an indirect measure.
Can PROC be used with other indicators?
Yes, the PROC can be used with other indicators to get the best out of it. However, it is important to combine it with indicators that complement it, such as trend-following indicators which can show the direction of the trend. Examples of such indicators include moving averages and trendlines. For instance, you can use a moving average to identify that the trend is up and look to enter long positions when there is an oversold signal or even a bullish divergence after a pullback.
What are the limitations of PROC?
The limitations of PROC include the following:
- The indicator shows the short-term momentum of the market, which can change at any time.
- It does not show the long-term direction of the market and, as such, cannot be used for long-term trading.
- The indicator is very sensitive to price changes and, thus, very prone to whipsaws and false signals.
- It is very dangerous to use the indicator as a standalone signal since it may not tell you the long-term direction of the market.
Is PROC effective in volatile markets?
No, the PROC is not effective in volatile markets, as it is very prone to whipsaws and false signals. When the market is very volatile or spiking up and down, the PROC indicator would crisscross the centerline, thus giving conflicting signals. This is why you should not use the indicator in volatile markets. If the PROC is a part of your trading system, make sure you have a way of identifying a volatile market so you stay out of it.
How does PROC perform in trending markets?
The PROC performs very well in trending markets if used the right way. This means trading only in the direction of the trend and never trading against the trend. If you trade in the direction of the trend, you can use the PROC to identify when a pullback is likely over so you can enter the market to ride the next swing in the trend direction. For instance, in an uptrend, an oversold signal or bullish divergence after a pullback to a support level can be an effective strategy with good performance.
What are common PROC trading signals?
Common PROC trading signals include the following:
- Centerline crossover signal: This occurs when the indicator crosses the centerline. Crossing above the line into positive territory indicates a rising momentum to the upside, while crossing below the line into negative territory indicates a rising momentum to the downside.
- Overbought and oversold signals: An overbought signal is when the indicator is at the extreme end of the positive territory, signaling that there may not be many more buyers left in the market. Oversold is when the indicator is at the extreme end of the negative territory, signaling that there may not be many more sellers left in the market.
- Divergence signals: These signal potential reversals. A bullish divergence occurs when the price is making a lower low but the indicator is making a higher low or the other way around. On the other hand, a bearish divergence occurs when the price is making a higher high but the indicator is making a lower high or the other way around.
How do you interpret PROC divergences?
You interpret PROC divergences the same way you interpret divergences of other oscillators. A bullish divergence indicates that the market may be about to reverse to the upside, while a bearish divergence indicates that the market may be about to reverse to the downside. It is best to interpret divergences in the light of the market structure and price action — a bullish divergence around a support level and a bearish divergence around a resistance level.
Can PROC be used for short-term trading?
Yes, the PROC can be used for short-term trading. In fact, it is best suited for short-term trading considering how sensitive it is to short-term price changes. However, it is best to combine it with another indicator that shows the long-term trend so you don’t fall into the trap of countertrend trading with the indicator.
How does PROC impact risk management?
The PROC does not directly impact risk management, as it does not determine your stop-loss level or your position size. However, you can use it to build a trading strategy, which you can backtest to determine the appropriate risk management parameters for your style of trading. So, the PROC adds to your overall trading system and, thus, can indirectly impact your risk-taking behaviors and your risk management approaches. Also, the PROC can show you when the market momentum has turned against your position if you aren’t using hard stops.
What are the best markets for using PROC?
The best markets for using PROC are any market with the right trend and volatility. Since the indicator is based on price alone, it can be used in any market with real-time price data, including stocks, futures, forex, and even bonds. What matters is that the market is trending nicely and not too volatile, but more especially, that you have a good strategy with the PROC that has been backtested and proven to have an edge in the market.
How does PROC behave in sideways markets?
How the PROC behaves in sideways markets would depend on the strategy used and how volatile the market is. If the market is in a reasonable range, you can trade from the support and resistance ends of the range — you look to go long at the support end if the PROC is showing oversold or has a bullish divergence, and you try to short from the resistance end if the indicator is showing overbought signal or a bearish divergence.
Can PROC identify overbought or oversold conditions?
Yes, the PROC can be used to identify overbought or oversold conditions. Traders use extreme values of the indicator to estimate when the market is in an overbought or oversold condition. When the indicator is at the extreme end of the positive territory, the market is said to be in an overbought condition. Likewise, when the indicator is at the extreme end of the negative territory the market is said to be in an oversold condition.
What role does PROC play in technical analysis?
The role PROC plays in technical analysis will depend on the trader’s trading strategy. However, being a momentum oscillator, traders generally use the PROC to track price swings and the momentum of each swing. In a trending market, they can use it to track the momentum of a pullback swing to know when the pullback is likely over so they can enter a trade in the trend direction and ride the next impulse swing.
How can beginners start using PROC effectively?
Beginners can start using PROC effectively by first learning how the market works and how to use indicators in trading. Then, they can focus on understanding the PROC and building a trading system with it. After building a trading system, they should backtest it and deploy it only if it is profitable.
What are the common mistakes when using PROC?
The common mistakes when using PROC include the following:
- Using the indicator to assess the long-term direction of the market
- Using the indicator as a standalone signal
- Trading without proper risk management
FAQ:
What is the Rate of Change (ROC) indicator, and how does it work?
The Rate of Change (ROC) is a momentum-based technical indicator that compares the current price of a security to its price “n” periods ago. It is plotted as an oscillator and moves above or below a zero line, indicating changes in momentum. The formula is (Current Price – Price “n” periods ago) / Price “n” periods ago.
What is the significance of the centerline in the ROC indicator?
The centerline (zero line) in the ROC indicator helps differentiate between positive and negative momentum. Positive ROC values indicate increased buying pressure, while negative values suggest selling pressure. Centerline crossovers are often considered indications of a trend change.
What are common ROC trading strategies, and how do they perform?
Common ROC trading strategies include oversold/overbought conditions, breakouts, zero line crosses, and divergence detection. Performance can vary, so backtesting and optimization are crucial before implementing any strategy. ROC can be useful for options traders. It helps observe the relationship between the price rate of change of an option to a fractional change in the price of the underlying security, known as the options delta.
