Understanding momentum indicator ROC
Though not visible in short term charts, standardisation helps in long term charts.
In previous issues, we covered different types of moving averages and trading rules associated with them. Since moving averages are trend following indicators, buy / sell decisions based on them may get delayed.
To make the analysis more efficient, technical analysts have developed several advanced indicators over the years. Though there are hundreds of indicators and more are added on a daily basis, we will discuss the ones that are most commonly used. Let us start with the rate of change (ROC), a momentum indicator.
Momentum – In technical analysis, momentum usually refers to the speed at which an uptrend or a downtrend is proceeding. Most of the time, momentum falls significantly before a trend is reversed. This is like a car reversing direction; it has to reduce speed and come to a halt before it starts moving in the opposite direction. By measuring the momentum, you can identify possible trend reversals. Momentum is calculated as the difference between today’s closing price and the closing price a few days ago. For instance, a 10-day momentum is calculated using the following formula:
ROC – To make the calculation more standardised, momentum is usually determined as a percentage, and this is known as ROC. For instance, the 10-day ROC is calculated by using the following formula:
Plotting – Unlike moving averages, which are plotted along with the price data, most of these new indicators like ROC are usually plotted in a separate window, above or below the price chart. As illustrated in the charts, both Momentum and ROC are almost moving together. So why should we calculate ROC, a standardised version of momentum? Though not visible in short term charts, standardisation helps in long term charts.
For example, because a 500-point change in Sensex is common now, but not few decades back when its value was in the range of 1000s.
Need for caution – Though indicators have the ability to generate faster signals, traders should be careful while using it. This is because every slowdown in momentum need not be a guaranteed trend reversal. Just like we slow the car and accelerate it several times in a journey, share price trends also can also take a pause in the middle.