What is the Rate of Change Indicator?

Professional investors use their knowledge to identify stocks that are undervalued and have the potential to increase in price in the near future. This allows them to enter the trades at a low price and sell when the price rises in the short term. If you too can identify stocks with future potential, you can enter at the right time and book profits in the short term. But, how?

The answer lies in a process called Technical Analysis and its various indicators used by investors to evaluate stocks based on their past patterns and predict their future prices. In this blog, you will learn about technical analysis and one of the most vital technical indicators called the Rate of Change Indicator. This will help you evaluate stocks based on their past and present price and buy them at the right time before the price increase.

What is Technical Analysis?

Technical Analysis is the study of chart patterns, graphs and diagrams on a screen. The idea is to understand price and volume trends and pick a specific stock. Technical analysis is based on the premise that historical price trends tend to repeat over time. In technical analysis, you sit with historical stock charts, look at price and volume data, and then plot various trends. Based on past wisdom, you find patterns to trade for the future. One of the most widely used ways to perform the technical analysis is to look at the past price patterns of the stock and compare them with the present price to understand the stock’s performance and potential.

What is the Rate of Change Indicator?

The rate of change indicator is a momentum-based technical indicator used in the process of technical analysis. The rate of change indicator is used to measure the percentage change in price between a price level pertaining to a specific time in the past and the current price of a stock. The rate of change indicator is measured against the value of zero. If the percentage change is positive and the price has moved higher, the rate of change indicator moves upwards. However, the price has fallen, the percentage change will be negative, and the rate of change indicator will reflect a downwards movement.

Based on the negative and positive outcomes of the rate of change indicator, investors can find the ideal entry and entry point by predicting where the price can go in the future as it has done in the past. Furthermore, investors also use the rate of change indicator to identify oversold and overbought levels, centerline crossovers and divergences.

How to calculate the Rate of Change?

Here is how you can calculate the rate of change:

ROC = [(Today’s Closing Price – Closing Price ‘n’ periods ago) / Closing Price ‘n’ periods ago] x 100

Here ‘n’ periods are the number of days, months, and years before today from where you want to calculate the percentage change. It also marks the starting point for the calculation of the rate of change indicator.

Method:

The most important step in calculating the rate of change is to determine the ideal ‘n’ value. The value of ‘n’ may be any number of days, such as 10, 20, 50 or even 200. Short-term traders use smaller values of ‘n’ as they want to sell their positions after some days. However, long-term traders may choose a value of ‘n’ as high as 200 if they want to hold the positions for longer. If the value of ‘n’ is smaller, the rate of change will react to the price change quickly. However, if the value of ‘n’ is as high as 200, the rate of change will react slower to the price change. You can follow the below steps to calculate the rate of change for any stock:

• Choose a value of ‘n’. This will be the point from where you want to identify the percentage change in the price of the stock.

• Next, find the most recent closing price of the stock. Ideally, it is the closing price of the last traded session.

• Find the closing price of the stock ‘n’ periods ago. For example, if your determined ‘n’ value is 50, you have to find the stock’s closing price 50 days ago.

• Put the values in the above formula to find the rate of change. You can calculate the new rate of change after every period ends.

What does the Rate of Change (ROC) indicator tell investors?

The main purpose of the rate of change indicator is to measure the strength of price momentum by the rate of change. It means that the rate of change indicator takes into consideration the price of a stock at a specific time in the past and compares it with the current price to give results. The rate of change indicator that is plotted against zero results in a positive value when the percentage change in the price movement has been upwards and shows negative values if it has been downwards.

For example, if you want to calculate the rate of change for a stock by comparing its price change from ten days ago to the last closing price, you can calculate it as follows:

• The stock’s price ten days ago was Rs 50.
• The stock’s last closing price was Rs 65.

The rate of change is calculated as:

((65-50)/10)x100 = 150

Investors look towards the rate of change indicator levels to understand the price level at which the trend for the stock reversed in the past. While looking at these levels, the investors may find both positive and negative signals. Now, suppose the calculated rate of change reaches these extreme levels again. In that case, the investors become cautious and closely monitor the price to see if it is reversing or continuing following the current trend. If the price reverses, investors can confirm the rate of change indicator. By analysing the rate of change signal and the price reversal, investors can consider buying the stocks. This is how the investors analyse the overbought and oversold conditions.

Furthermore, investors use the rate of change indicator as a divergence indicator to predict a possible change in the market trend. Ideally, a divergence situation occurs when the rate of change moves in the opposite direction of the stock’s price direction. For example, if the stock is rising in price constantly, but its rate of change is falling, it could mean that the current trend is likely to reverse, and the stock price may fall in the coming days. In such a case, investors can either book profits or adjust their holdings to mitigate the risk profile and potential losses.

Limitations of using Rate of Change Indicator (ROC)

Here are the limitations of the rate of change indicator:

• It is not generally used for trading as it is prone to whipsaws around the zero line.

• As it gives equal weight to both the ‘n’ price and the last closing price, it is considered to be less effective.

• The divergence signal occurs very early, allowing the price to run in the same direction even after the signal.

Final Word

The rate of change indicator is an effective technical indicator that investors can use to evaluate and analyse stocks and find the ideal entry and exit points. As it measures the speed at which prices are changing, you can utilise the indicator to make informed investing decisions.