Price Rate Of Change Indicator – Formula and ROC Trading Strategies

2023.02.06 2023.02.06
Price Rate Of Change Indicator – Definition, Formula and the ROC Trading Strategies

Oleg Tkachenkohttps://www.litefinance.org/blog/authors/oleg-tkachenko/

The ROC indicator is one of the momentum indicators often employed in intraday strategies, which allows you to evaluate the rate of price change compared to previous periods. It can be used to assess the trend strength and spot pivot zones. ROC is a leading oscillator whose signals are used as confirmation signals to predict the trend change.

The article will explain what the ROC indicator is, how it is calculated, and what its advantages and disadvantages are. You will also get acquainted with the indicator signals and ROC trading strategies.

What is the Price Rate Of Change Indicator?

The ROC (Rate of Change) indicator is a tool that shows in percentage terms the difference between the current price and the price several periods ago. In different types of analysis, it acts as both an oscillator confirming the trend movement and a trend-following indicator. The simplest interpretation of its signals is if the indicator curve is growing, it means that the asset’s current price is moving away from the previous values, trader sentiment is bullish, and the trend is going up. If the ROC value goes down, sellers lead the market.

Advantages of the ROC indicator:

• Clear logic of calculation. The indicator compares the current price with the price of the period specified in the settings and displays the percentage value of the deviation through the ratio of the difference to the recent price and the recent period. The zero level is the median. If the indicator is moving sideways at the zero level, it means the market is trading flat‎. Lateral movement above or below the “0” level indicates a smooth and stable trend.

• Open code. Although the indicator is not basic for some platforms, its code is open. For example, its revision can be ordered on the MQL5 website in the “‎Freelance”‎ section.

• Clear interpretation of signals. If the indicator line is growing and has passed the zero level, there is confirmation of the positive momentum.

• If the indicator moves away abnormally from the zero level, this is the ROC signal for a soon reversal. The Rate of Change indicator is an oscillator, so its signals are leading.

The Rate of Change indicator has quite a few settings. On the one hand, it makes the indicator user-friendly for beginners. On the other hand, one cannot change many parameters, which limits the indicator application.

Drawbacks of the ROC indicator:

• High sensitivity to price changes. Indicator values are not averaged, so the period plays a major role. A sharp price surge due to abnormal fundamental volatility can lead to a sharp jump in the indicator values, which will disappear when the period changes. The disadvantage is partially eliminated by setting a longer timeframe, where sharp reversals and movements are smoothed out in candlesticks.

• The need for constant optimization. The Rate of Change is sensitive to volatility. If the volatility has changed, you need to revise the period. Otherwise, the indicator will turn into a lagging one and give false signals of the trend direction change.

Like other technical tools, the ROC indicator could send false signals. One can filter out false signals by selecting optimal settings in the strategy tester on a demo account.

Formula of the Price Rate of Change

An interesting fact is that in different sources, including the theory of technical analysis, there is no single approach to the calculation formula of the indicator. The situation is also complicated by the fact that one of the ROC formulas completely coincides with the formula for calculating the Momentum indicator. However, Momentum also has two calculation formulas. The difference in the formulas is due to which level, “0” or “100”, is the median, the indicator value is determined in percentage or in quantitative terms, etc. But in all sources, the opinion is the same: minor changes in the formula do not change the principle of the ROC, which measures the rate of price change.

How to Calculate the ROC Indicator

There are several methods to calculate the price rate of change in the roc technical analysis:

1. This formula is suggested by Stephen Akelisin in the book Technical analysis from A to Z. The Rate of Change is calculated as the difference between the current price and the price of the previous period.

ROC = P(i) – P(n)

P(i) is the current price, and P(n) is the price of n periods ago. A similar approach was initially applied to Momentum, with the only difference being that ROC showed a numerical value, and Momentum was calculated as a percentage. Since the percentage ratio is more convenient in terms of perception of price changes, it was decided to abandon this formula over time. But in some sources, it is still found.

2. This formula for calculating the ROC is proposed in the book Technical Analysis of the Futures Markets by John J. Murphy. Instead of the difference, this formula uses the ratio of the current price to the price for the previous period.

ROC = P(i)/P(n) × 100%

Here, the median level is “100”, which is the key to identifying signals. In modern trading, it is this formula that corresponds to the Momentum indicator, which introduces some confusion. For example, it is offered for Momentum calculation on the MetaQuotes MQL5 website. And this can be seen in the code of the indicator itself, which is the base indicator for the platform.

3. This ROC formula is presented in new publications on technical analysis and is also listed on the MetaQuotes website.

ROC = ((P(i)-P(n)/P(n)) × 100%

This version of the ROC equation is used in the Metastock and CQG software packages, as well as in many forex broker trading platforms, including the LiteFinance terminal.

How to distinguish Momentum from ROC? If the median level is “100”, this is Momentum, which is calculated using the second formula. If the median level is “0”, this is the ROC, which is calculated by the third formula.

How to Interpret the ROC

Primary signals of the price rate of change indicator:

1. Divergence. This is a situation when the Rate of Change indicator and the price trend are moving in opposite directions. Divergence is one of the strongest signals meaning that the market should soon turn in the direction of the indicator. The bullish divergence is detected using lows. The indicator lows are rising while the price lows are getting lower. The bearish divergence is constructed by highs. The ROC highs are getting lower, and the price highs are getting higher.

Example.

With a relatively small scale, the divergence is visible in the daily chart. The price highs are rising while the indicator highs are falling. This is followed by a sharp drop in the Rate of Change, the line crosses the zero level, confirming the downtrend. The price also goes down. Since the timeframe is daily, one should wait for the ROC to cross the “0” level and only then enter a trade. The remaining 4-5 candlesticks of a downward movement are enough to make a profit with almost no risk.

2. Overbought and oversold conditions. If the indicator line breaks far from the zero level and enters the overbought or oversold zone, the price will soon reverse.

This shows a simple example. If the current price is 50 USD, and the price 10 days ago (10 candlesticks ago in the daily chart) was 50 USD, the numerator will be zero. If on the next candle, the price abnormally goes up to 60 USD, while 10 days ago, the price rose only by 1 USD, the numerator will immediately show a value that will sharply raise the indicator also up. The cause of the sharp price move may be a fundamental factor. And after the stabilization of the situation, the ROC indicator will return to zero.

The issue is that ROC does not have highlighted overbought and oversell areas. They need to be drawn manually. To do this, we reduce the chart scale to the minimum and draw horizontal lines along the largest number of the price extremes.

Example of a long-term ROC trading strategy

The horizontal lines are drawn visually, and the arrows show the deviations from the usual range of the indicator movement. False signals are marked by numbers “3” and “5”.

In this example of the ROC indicator strategy, the following point may not seem entirely logical: only 8 signals for the period from September 2017 to September 2020, of which 2 are false. Note that:

• This is just one example of building levels. You can experiment with scaling, levels, and timeframe as you wish. Zoom in and build a narrower range, you will get more signals that will be less accurate.

• This is an example of a conservative long-term strategy in a daily timeframe. For example, the price movement on the signal “1” is 430 pips in 4-digit quotes for 3 calendar weeks. The profit is 43 USD with a minimum position volume of 0.01 lots. To open a GBP/USD position with a minimum volume of 0.01 lots at the exchange rate of 1.2 without leverage, you need 1200 USD. There are 52 weeks in a year; therefore, the return on investment without leverage (!) would be 62% per annum. The calculations do not consider the swap, which will reduce the profit.

You can additionally filter the overbought and oversold zones using the RSI indicator.

3. Zero line crossing. If the Rate of Change is moving near the zero line, this indicates market consolidation, trading flat. This moment can be used to spot the beginning of a trend, which will be indicated by the indicator’s deviation from the zero line. A stronger confirmation signal would be a crossing of the zero level.

This type of signal is confirming. If you enter a trade based on zero crossing as a primary signal, you will enter the market too late. 

Example:

Several zones are visible in the EUR/USD hourly chart. The downward movement of the ROC confirms the price movement down, and the indicator crossing the zero line would be a timely signal to open a short position.

The next zone displays trading flat, which is confirmed by the small body of most candlesticks. The question is that this is clearly visible in the chart history, but at the current moment, the ROC crossing of the zero level from the bottom up could be taken as a signal for an uptrend. This example shows why the movement of the Rate of Change relative to the zero level is only an auxiliary signal.

A strong signal is when the Rate of Change crosses the zero level and goes quite far from it. The screenshot shows that the ROC has entered the overbought zone and started a reversal; it is a good signal to open a short position.

The same chart 24 hours later:

The chart shows that the price was going up for one more candlestick after the reversal signal, after which it reversed. In this case, the signal to close the position will be a ROC reversal upwards below the zero level.

How to use the rate of change oscillator in technical analysis?

For beginner traders, the ROC technical indicator is convenient because it has almost no settings to alter. The main parameter is the period. It means which candlestick in the account back from the current one is used in the calculation. An additional parameter is the price type: close price, open price, high, low, or average price. The default period is 9. This is the optimal parameter for major currency pairs in the hourly timeframe. With such a period, the Rate of Change gives signals one or two candlesticks ahead, which are more than 70% profitable. For scalping, the period can be reduced, and for daily timeframes, it can be increased.

Trading strategies using ROC Indicator

Now, I shall move on and explain how to trade with ROC indicator. Let us look at an example of a simple strategy employing the price rate of change indicator, which does not require complex indicators. Input data: daily timeframe, AUD/USD, and ROC (9). The daily timeframe is taken to catch even small price movements, spending no more than 20-30 minutes a day to control the indicator chart and the price.

1. Build a trend line of a downward movement along two clear highs. The downward movement ends sooner or later, so the goal is to search for a signal that indicates its reversal. The trend line is the main tool, the ROC oscillator is the confirming supplementary tool.

2. Define the levels of overbought and oversold zones. They are useful for assessing the market condition and defining profit targets.

3. Expect the trend reversal signal.

The signal appears when the trend line is broken out, and the price bounces up from it. But the breakout can be false, so we get a confirmation signal from the ROC. The indicator, after moving down, was near the zero level, then it started an upward movement. At the opening of the next candlestick, you can open a position.

There are several options for profit targets in the rate of change indicator strategy. For example, when ROC enters the overbought zone, you can close a part of the position. A take-profit can be set at the level of the second extreme, according to which the trend line was built. Stop loss is calculated depending on the position volume and the deposit amount in accordance with the risk management rules.

Overbought and Oversold

Overbought and oversold zones, as well as divergence, are the strongest signal. The disadvantage of the Rate of Change is that it does not define these zones. You set the limiting levels yourself, so the signals received are subjective. The example above showed that the indicator reversal in the overbought and oversold zone does not guarantee a quick price reversal. ROC, after repainting, continues to move away from the zero level. This point must be taken into account when setting stop-loss orders.

Recommendations on trading based on the overbought and oversold zone using the ROC indicator:

• Build levels at the smallest possible scaling.

• Set stop loose at an ample distance or watch the price after a trade is entered. Manual movement of the stop is allowed if the price went in the opposite direction to the forecast, and increasing the length of the stop does not contradict risk management.

• Analyze fundamental factors. For example, if the ROC is reversing in the overbought zone, but there are fundamental reasons for further price growth, do not rush to open a sell position.

• Build several lines similar to Pivot points. For example, the first level is the level of the most frequent reversals. The second one is rarer, the third one is the maximum level reached by the price rate of change oscillator for the selected period.

There are some strategy options. You can set very narrow overbought and oversold zones. It will give rare but accurate signals. Or you can set wide zones. The signals will be frequent, but you will have to use additional filters.

Best markets for using the ROC oscillator

The Rate of Change does not work well in trading flat, so it is better to use it in a trending market. It shows well the trend movements of the stock market: stocks, indices, and blue chips. It can also be employed in trading exotic currencies. The ROC stock indicator is applied in the same way as in the foreign exchange market.

Tips on using the ROC indicator:

• Alter the settings considering the asset volatility. Calculators will tell you the average volatility for the period. You can read more about this in the article What is volatility?

• Add filters. The main indicator of the trading system is trending, Rate of Change is a confirming tool for other reversal signals.

• Analyze multiple timeframes. First, study the ROC dynamics in a longer-term timeframe. If the direction of the oscillator in the longer and shorter timeframes are the same, this is a strengthening signal.

   

The Rate of Change is a versatile tool, but the settings should be adjusted to each market.

Stocks rate of change

The rate of change stock indicator is more effective since the stock market is characterized by longer trends, deep drawdowns, and the absence of an upper price ceiling compared to the foreign exchange market. The rate of change stocks price is more stable, without sudden movements. Therefore, it is easier to use it to determine local pivot points during corrections.

You can see from the screenshot that, in most cases, the stock rate of change clearly shows the trend movement of different strengths. The rectangle represents the divergence.

Which indicators are similar to the ROC?

One of the similar basic indicators is Momentum. It is a leading oscillator that is placed below the price chart and moves relative to the median value of “100” with no restrictions on the range of motion.

The Momentum calculation formula:

Momentum = Close(i)/Close(i-n) × 100%

It differs from the Rate of Change by the formula for calculating the price deviation from its value n periods ago (n value expresses the period). Its signals are interpreted similarly: divergence, the reversal in the overbought and oversold zone, and crossing the zero line.

With the same calculator periods, the indicators look like this:

The price rate of change chart readings are similar. 

You can learn more about the indicator, its signals, and examples of its use in trading systems in the review devoted to the Momentum indicator.

Limitations of the ROC

1. The problem of different approaches to the calculation formula. For MT4/MT5 platforms, the Rate of Change is not a basic tool. It needs to be added through the data catalog. The question is from what source it will be taken, namely, what calculation formula is used in it. Indicators with different formulas will give different signals and, accordingly, these will be fundamentally different trading systems.

2. Short timeframe. In M1-M5 timeframes, the indicator gives a lot of false signals due to price noise and a sharp change in the direction of the future price movement. Partially, the problem can be solved by adding smoothing using moving averages to the ROC formula. But the indicator is more often used in timeframes from H1 and longer.

3. Fundamental volatility. The publication of economic data and news releases can greatly influence the price in the short term, and the Rate of Change will give false signals at these moments. At the moments of key news, try not to enter trades and ignore the signals of the price indicator. You can find news dates and times in the economic calendar.

Conclusion

Rate of Change key takeaways:

• The Rate of Change is a leading oscillator that allows you to see indicative overbought and oversold zones. It is used to search for signals that indicate an imminent change in the trend direction; it determines sideways movements relatively well.

• Main signals: divergence and reversal in the overbought and oversold zones towards the zero level. An additional signal confirming the trend movement is the indicator crossing the zero line upside or downside.

• Scope: the ROC is used on any assets in timeframes from H1 and longer. It works better on a trending stock market but is also effective on major currency pairs.

• It is used in trend strategies and swing trading as a confirmation tool. Price action patterns and additional oscillators are used as a filter.

Note! Unlike MT4/MT5, this indicator is already built into the LiteFinance platform. You can test the price ROC indicator trading strategies on a demo account for free without registration.