This Versatile Indicator Helps Spot Turning Points

Momentum in its simplest form is the Rate of Change (ROC) indicator.

This indicator shows the percentage change in price over a specified time frame. There are many other momentum measures, but they all modify this basic calculation in some way.

To calculate the ROC, divide the current price by an earlier price. Subtract 1 from that value and multiply by 100 to convert to a percentage:

Rate of Change (ROC) = [P/P(t)] -1 x 100, where P(t) is an older price point

For example, dividing the current price by the closing price six months ago will give the 6-month ROC.

This calculation can be applied to any type of data series, including stocks, ETFs, mutual funds or even economic data. (In fact, the widely followed Consumer Price Index (CPI) is a 12-month ROC calculation of price change.)

How Traders Use Rate Of Change

Traders can use ROC by itself as a complete trading strategy. Traders could buy when the ROC is positive and sell when it falls below zero. You can see this at work in the chart below. In this example, you would have made two large gains and avoided one large loss.

FXI Rate of Change

Some traders add a moving average to the ROC and trade based only on that. Buy signals occur when the ROC crosses above the moving average. Sell signals occur when the ROC falls below its moving average.

Traders use a variety of time periods for the indicator or the average. But a 26-week ROC with a 13-week moving average are common settings.

In addition, traders can identify bull and bear markets by the value of ROC. Bull markets will have a positive value and downturns will be accompanied by a negative ROC.

Why Rate Of Change Matters To Traders

ROC is a versatile indicator. It identifies opportunities for trading, spotting bubbles, and many other purposes.

A number of studies have shown that high-momentum stocks tend to outperform over the next three to twelve months. Traders can screen for the stocks with the highest ROC and buy them. ROC will often turn lower and fall below its moving average ahead of a major price decline. This offers a timely sell signal. It is also helpful to see when ROC turns negative, since that is often a signal that more price declines are ahead.

For spotting possible bubbles, consider our FXI example. Before it collapsed, the price of iShares FTSE China 25 Index Fund (NYSE: FXI) doubled in only six months. The ROC was above 100% at that time. Price advances like this are generally unsustainable.

By following ROC, potential crashes can be avoided. Whenever the 6-month ROC is above 50%, for example, the advance is unlikely to continue.

Traders could also add Bollinger Bands to the ROC to help spot turning points.

When ROC is above the upper Bollinger Band it is more than 2 standard deviations above average. This is something that should happen less than 2.5% of the time. This is a warning that prices have advanced quickly and a reversal could be near. On the flip side, an upward move in prices would be expected when ROC falls below the lower Bollinger Band.

By setting the Bollinger Bands to be 3 or more standard deviations from the average, something that is easily done with almost any trading software, you can spot even rarer market extremes. Only 1% of all ROC readings should be more than 3 standard deviations from the average. These rare opportunities will generally represent low-risk entry points for trades.

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