Rate of Change Indicator (ROC) – Trading Strategy and Tips

The Rate of Change (ROC) indicator measures the momentum of price movements and can be used by traders to gain valuable insights into the direction of price changes, helping them stay ahead in the market.

In this guide, we will cover everything you need to know about the ROC indicator, including how to use the indicator and implement the ROC trading strategy. 

What is the Rate of Change (ROC) Indicator, and How Does It Work?

The Rate of Change (ROC) indicator is a potent technical analysis tool used to analyze the momentum of price movements. Developed by Fred G. Schutzman, ROC provides valuable insights into the speed and direction of price changes, making it a crucial element for traders seeking to stay ahead in the market.

Like many other indicators, it is a sub-chart indicator with one trend line representing the market momentum. Here’s what the ROC indicator looks like on a price chart:

As a momentum oscillator added to the sub-chart, ROC effectively highlights overbought and oversold levels, which can be adjusted based on trending market conditions. While securities might linger in these extreme zones, it’s essential to understand that indicators primarily offer a snapshot of market momentum and trends, aiding traders in making informed decisions.

Technically, positive ROC values or high momentum levels indicate that a security is likely to outperform the broader market in the short term, usually spanning 1-6 months. On the contrary, lower momentum signals a more bearish performance, guiding traders to be cautious in their strategies.

For advanced traders, leveraging relative momentum by comparing the momentum of different stocks or against a broad market index, like the S&P 500, can lead to the formulation of profitable trading strategies.

Overall, the indicator serves a vital role in measuring the average change in the price of a security over time, referred to as the price rate of change. This aspect also proves valuable for options traders, enabling them to observe the relationship between the price rate of change of an option and the fractional change in the price of the underlying security, often known as the options delta. It is, therefore, among the most widely used indicators incorporated in various options strategies.

ROC Indicator Formula

Now, let’s delve into the formula used to calculate the ROC indicator. It is a straightforward calculation that requires the current closing price and the closing price “N” periods ago.

The formula is as follows:

ROC = [Current Closing Price – Closing Price N periods agoClosing Price N periods ago] 100

By inputting the relevant values into the formula, traders can derive the ROC value, representing the percentage change in price over the specified look-back period.

How to Use the Rate of Change Indicator in Trading

Integrating ROC into your trading platform can offer crucial signals for identifying breakouts, trend reversals, and profitable trading opportunities. Here are some effective techniques for utilizing the ROC indicator to enhance your trading strategies.

Breakouts

A primary application of the ROC indicator lies in spotting breakouts with robust momentum. Generally, breakouts occur when a security’s price surpasses a significant level of support or resistance, typically following a period when the market trades inside a range, signaling a potential continuation of the existing trend. By observing a sustained sharp rise or fall in the indicator values, traders can confirm the strength of such breakouts, boosting confidence in trend continuation and uncovering more breakout opportunities.

Zero-Line Crossovers

The zero line on the ROC indicator plays a pivotal role in detecting new trends. ROC crossing above the zero line to a positive territory signifies a bullish trend reversal, indicating opportunities for buying. Conversely, when ROC crosses below the zero line to negative territory, it suggests a bearish trend reversal, pointing to potential selling opportunities. 

However, to minimize false or reversal signals from zero-line crossovers, traders should consider the asset’s volatility and the chart timeframe, complementing the crossover with other indicators or price action confirmation.

Divergence

Like any other indicator’s divergence, divergences between the ROC indicator and price chart can offer valuable insights into potential trend reversals. A bearish divergence occurs when the price chart forms a higher high while the ROC line plots a lower high, indicating a potential loss of uptrend momentum and an impending reversal. On the other hand, a bullish divergence occurs when the price chart forms a lower low while the ROC line shows a higher low, suggesting a potential switch from a downtrend to an uptrend.

Hidden divergences can also provide vital continuation signals. Hidden bearish divergence emerges when the ROC makes a new lower low while the price fails to make a new lower low, signifying a bearish trend continuation. Conversely, hidden bullish divergence arises when the ROC makes a new higher high, while the rising price fails to make a new higher high, suggesting a continuation of the bullish trend.

Rate of Change Indicator Trading Strategy Tutorial

Let’s explore two effective trading strategies using the ROC indicator: the breakout trading strategy and the ROC overbought and oversold strategy. These two strategies help traders identify areas where the market might reverse or continue in the same direction.

ROC Indicator Breakout Trading Strategy

The ROC indicator is useful for identifying potential trend reversals. However, the indicator is also extremely effective in identifying areas where the market breaks above or below a certain support or resistance. 

To illustrate, let’s consider a range-bound market scenario where the price oscillates between well-defined support and resistance levels.

As you can see in the EUR/USD chart above, when the ROC indicator signals a breakout by showing a sustained sharp rise above the zero line, it confirms the potential continuation of an upward trend.

Likewise, a sharp decline below the zero line indicates a potential continuation of a downward trend. However, to further validate the breakout signal, traders often employ another indicator, such as a moving average or Bollinger Bands.

By combining the ROC indicator with a moving average or exponential moving average, traders can increase their confidence in the breakout signal. For instance, if the ROC has just made a sharp rise above the zero line to signal an uptrend, traders can wait for the 9 EMA to cross above the 15EMA, further confirming the trend change and providing an optimal entry point for a short trade.

Stop Loss

Upon using the ROC breakout trading strategy, place your stop loss below the most recent swing low in a bullish breakout scenario (as seen in the image below). On the other hand, in a bearish breakout scenario, place your stop loss above the bearish breakout scenario.

Take Profit

Take your profit when you get an opposing signal from the moving averages, meaning a crossover between the slow and fast-moving averages.

ROC Overbought and Oversold Strategy

Another valuable aspect of the ROC indicator is its ability to identify overbought and oversold conditions in the market. When the ROC value moves significantly above its upper threshold (say, 1), it indicates that the asset is overbought and may experience a price correction.

Conversely, when the ROC value drops significantly below its lower threshold (say, -1), it signals an oversold condition, indicating a potential price rebound.

Note that while this strategy can be used to identify trend reversals, it can be used to identify areas where you might want to exit a trade. 

Let’s see an example of how this strategy works:

Now, once the oversold or overbought level is triggered, wait for the price to start making a turn in the direction of the reversal.

To increase the accuracy of the ROC signal, it’s best to add another indicator, such as Fibonacci retracement levels. To do so, draw your Fibonacci from the most recent swing high or low of the price movement before the overbought or oversold level to the end of the trend.

Your trade entry is to buy or sell into the levels of the Fibonacci retracement tool.

Take Profit and Stop Loss

When using the ROC indicator with Fibonacci levels, you can use any of the Fibonacci levels as your take profit or stop loss levels. Taking the above example, your take profit levels are your Fibo retracement levels, starting from 0.5 and upwards. And your stop loss is just beneath the end of your previous trend.

Rate of Change Indicator – Pros and Cons

Although the ROC indicator provides us with valuable insights into market momentum and potential price movements, it also comes with its own set of pros and cons. Here are what to take note of while using the ROC indicator:

Benefits of Using the Rate of Change Indicator

The ROC indicator is a leading indicator, meaning it can provide early signals of potential trend reversals and changes in market momentum. This feature allows traders to stay ahead of the curve and make timely trading decisions. That’s why the ROC indicator is a favorite trading indicator among many traders. 

When in doubt, it also helps confirm the strength of price trends. When the ROC value aligns with the price movement, it provides traders with added confidence in the prevailing trend’s sustainability.

Limitations of the Rate of Change Indicator

Generally, using technical indicators requires some additional observational skills, like knowing when they work and when they don’t. And like many other leading indicators, that’s the main limitation of using the ROC indicator. In choppy or ranging markets, the ROC indicator may produce false signals, leading to potential losses or whipsaws.

Frequently Asked Questions About Trading the ROC Indicator

Here are some of the most common questions about the ROC indicator:

Is ROC a leading or lagging indicator?

The Rate of Change (ROC) indicator is a leading indicator. It provides insights into potential trend reversals and changes in momentum before they occur. By comparing the current price to the price “n” periods ago, ROC can anticipate shifts in market sentiment and identify breakouts or breakdowns. Traders use ROC to stay ahead of price movements and make informed decisions to capitalize on emerging trends.

How can I add the ROC indicator to MT4?

The Rate of Change (ROC) indicator is not pre-installed in MetaTrader 4, so you’ll have to download and install it as a custom indicator. First, find the indicator file on the Internet or MetaQuotes Ltd. website. 

Then, to install it in MetaTrader 4, navigate to File, select Open Data Folder → MQL4 → Indicators, and paste the file there. After restarting the terminal, ROC will be available in the Custom Indicators folder. To use it on a chart, go to Insert → Indicators → Custom → ROC in the program’s main menu. 

Typically, it’s used with the default settings (Rperiod=12), but you can customize the color and style of the main line.

What is the difference between the Rate of Change (ROC) and the Momentum indicator?

While both the Rate of Change (ROC) and the Momentum indicator are used to measure price momentum, they calculate momentum differently. The ROC indicator measures the percentage change in price over a specific period, comparing the current price to the price “n” periods ago. It plots this value on an oscillator above or below a zero line. 

On the other hand, the Momentum indicator calculates momentum by simply subtracting the closing price of “n” periods ago from the current closing price and plots the result as a single line on the chart. Despite these differences, both indicators serve a similar purpose of providing insights into market momentum, potential trend changes, and overbought/oversold conditions, enabling traders to make informed trading decisions.