I have an easy way to illustrate:
My sister has been on calcium supplements ever since a nail technician commented that her nails grow very slowly and then went on to suggest that maybe she had a calcium deficiency. Everyone in the family teases my sister about how she let her nail technician turn into her nutritionist but the fact is that the nail technician drew an expert's inference from the growth rate of my sister's nails from one nail appointment to the next.
Now friend, I broke off into that story in order to illustrate how rate of change is employed in the stock market. In the same way that the nail technician drew an inference from the rate of growth displayed by my sister's nails … in the very same way… traders draw expert's inferences from the rate that a stock price changes from one period to another. Note that a period can be any chosen period, an hour, a day… a few seconds.
ROC is illustrated as an oscillator and appears in a distinct window. This separate window is usually displayed as a rectangle below the stock price chart. Another graph is seen in this window.
Let us have a look at how traders plot the ROC oscillator on a stock price chart:
The ROC is plotted against a zero line.
The stock price moves above the zero line into positive territory when the stock price increases.
Conversely, it moves below the zero line into negative territory when the stock price decreases.
Are you ready to calculate RoC? Here is a step by step how-to:
Step 1: identify the most recent closing price of the stock in question.
Step 2: select a number, any number. If you are a beginner choose a lower number such as 8 or 9 or 14. This is the number of how many periods or days ago your stock price is to be compared to. We're going to refer to it as " n " going forward.
Step 3: identify the closing price at n periods ago.
Step 4: Minus the closing price at n from the current closing price.
Step 5: Divide this number by the closing price at n
Step 6: Multiply this number by 100.
And there you have your ROC! You want to try it with actual numbers? Sure! Why not...
Let's say the current closing price is 15 and the closing price at n was 11.
Minus 11 from 15… giving you 4
Then you divide this number by 15… giving you about 0.27
Then you multiply this by 100… giving you 26.67 which us your ROC.
A new ROC needs to be calculated for every new period.
Traders use ROC to determine an oncoming change in the price trend direction.
For example, a trader may line up ROC levels at which stock prices reversed in the past. When the ROC nears those values amidst the current stock price trajectory, the trader considers this to be an ROC signal that the stock price is about to reverse. He will watch closely for a price reversal to confirm the ROC signal… if and when this price reversal occurs, the trader will make his move to buy or sell depending on the direction of the price reversal.
Another trader may watch the ROC's distance from the stock price graph. When the stock price and the ROC move in opposite directions, the trader considers this to be what is called a divergence. This divergence too is an ROC signal that the stock price is about to reverse and trade will lie in wait for a price confirmation in order to make a trade. The problem with looking at divergence is that it gives no indication of how long it will take for the price reversal to take place.
The precision of ROC increases in direct correspondence to the value of n. In other words an ROC calculated with the value of n being 200 is likely to be more precise than an ROC calculated with the value of n being 12.
Additionally the value of n determines whether the signal will come earlier or later in the trend change. If you recall, we learned that beginner traders should choose a low value for n. And now you will see why: basically when a low value for n is used, the signal comes earlier in the trend change whereas if a high value for n is used the ROC signal will show up later in the trend change.
A word of caution however: a lower value for n also corresponds to a higher number of false signals… as a result, traders must most definitely wait patiently for the price reversal to actually manifest, before making any trades. While we are underscoring the need to wait for price confirmation, don't forget what we learned about ROC-stock price graph divergence… it does not tell you when the price reversal will occur, and as a result, once again waiting for the price confirmation is absolutely imperative.
And of course, friend, always remember to stack your predictions against multiple indicators before making a trademark. Also consider your risk appetite before investing. Happy trading!