Tracking Price Speed and Direction
Before stepping onto a pedestrian crossing, we make an estimate of the speed of an oncoming car. It may be unsafe if there is no change in its speed as it gets closer. Just like assessing the speed of the approaching car, we need a way of assessing the speed of how price is changing on stocks. A momentum indicator like the Rate of Change indicator (ROC) can help us gauge the speed of price and the likelihood of price continuing in the same direction or turning against us.
Starting with Trend Direction
The first thought after we identify a trend or breakout is probably on how much more the price will move up. Spotting a general trend direction using a trend indicator like the GMMA is often a simple observation. Identifying the potential for further movements in price, price reversals and tops or bottoms is a little bit trickier. We need additional indicators.
Using a momentum indicator like the Rate of Change indicator (ROC) may help gauge the speed of price and the likelihood of price continuing in the same direction.
Rate of Change ROC
The Rate of Change (ROC) indicator is a price based momentum oscillator used in short-term trading to gauge the speed and direction of price movements. It reflects a change in price momentum and is a warning sign of a change in direction before it happens on the price chart.
Momentum is a rate of change of price.
The ROC formula is as follows:
For a 14 day ROC, the formula looks like this:
ROC = [(Today's Close Price – Close Price from 14 days ago) / Close Price from 14 days ago] x 100
Most trading platforms have the ROC indicator.
One of the first considerations in using the indicator is setting the “n” value. The number of periods ago compared to the current price.
Time Values and Timeframes
Consider these suggested “n” values depending on the timeframe we wish to measure.
Any value for “n” may be inserted depending on the period you wish to measure. Keeping in mind the lower the “n” value the quicker the response to price changes.
Some view the “n” value of 200 as too slow for investors. Play around with the values to suit your situation.
READING THE ROC SIGNALS
The ROC signal line is set at 0
ROC line crossing above the signal line → bullish. Potential buy signal.
ROC line falling below the signal line → bearish. Potential sell signal.
ROC hovering around the signal line at 0. Price is consolidating.
Rising ROC line in an Uptrend
A rising ROC line suggests an upward trend is gaining momentum. Buying pressure is strong and prices are accelerating upwards, indicating potential buying opportunities for short-term traders.
A very high ROC might indicate the asset is overbought in the short term. The definition of overbought is determined by the individual trader, varying according to a particular stock’s characteristics.
Keep in mind the risks and volatility of a strong uptrend as it may be due for a correction or a consolidation.
Falling ROC line in an Uptrend
A falling ROC line suggests an uptrend is losing momentum. The uptrend is weakening. There is a possibility of a short-term pullback in price within the uptrend.
If price makes higher highs while the ROC makes lower highs then a bearish divergence may indicate a future trend reversal.
Falling ROC line in a Downtrend
A falling ROC line suggests a downtrend is losing momentum. Prices are accelerating downwards, indicating potential selling opportunities for short-term traders.
A very low ROC might indicate the asset is oversold in the short term, and a price bounce could be coming.
Rising ROC line in a Downtrend
Sometimes this may signal a weakening downtrend. Selling pressure slows down and may lead to a short-term bounce.
If price makes lower lows while the ROC makes higher lows then a bullish divergence may indicate a future trend reversal. The downtrend may be losing momentum.
Chart Analysis
Using the following daily chart of WA1 Resources Ltd – WA1 we demonstrate how to read the GMMA trend indicator together with the ROC indicator. In this example “n” is set at 9.
Starting at the left side, the GMMA indicator shows no trend. Compressed exponential moving average lines in both groups reflects an agreement in price from traders and investors. The ROC indicator below price, hovers around the zero line. Price is consolidating and there is no momentum.
Band 1
Once price begins to move together with expansion in the short-term GMMA and long-term GMMA groups, the ROC rises above the zero line. Momentum is increasing as traders and investors increase their buying activity. The lines in both groups separate out reflecting the strength of the trend.
From the peak in band 1, price starts to decline. The ROC turns down as momentum eases, serving as a warning signal of the breakout losing acceleration.
Band 2
Traders lose interest, the short-term GMMA group compresses and the ROC rose briefly above the zero line. Not an ideal set up combination for a good breakout.
Band 3
ROC rises above the zero line and trader buying increases again as reflected in the short-term group. The expansion of the lines in the short-term GMMA are a stronger breakout signal when paired with the rising ROC above zero.
Notice the bearish divergence as price made a higher high, the ROC indicator made a lower high. Price began its decline with traders selling off the stock. The short-term GMMA turned downwards and the slowing momentum of the breakout reflected in the ROC line also turning down.
A short-lived breakout opportunity occurred in the area between band 3 and band 4. It’s always a good idea to have a plan in place for stop losses and profit protection in the event of price retracement.
Band 4
ROC line rose above zero in line with the expansion of the short-term GMMA and long-term GMMA groups. The exponential moving average lines of each group separated out and upwards as traders and investors increased buying and support of the stock. This combination shows a strong breakout occurring as the ROC signalled price accelerating upwards.
The ROC is not a standalone indicator. Paired with GMMA breakouts and trends, it adds further evidence on whether price has strong momentum, slowing momentum or facing a potential change in direction. Gaining this extra advantage helps us stay out of the trades where breakouts and trends are on the low probability side of continuing into the future.