Rate of Change (ROC) Indicator in Stock Market: Meaning, Formula & Interpretation

A rate of change is an important indicator in stock market trades and investments that tracks how rapidly the price of an asset changes over a specified time.

When an asset’s price fluctuates, it calculates its changes in percentage by comparing an asset’s current price with the price at the start of the lookback period. It captures both upward and downward movements.

With the rising stock market participation in India, with 13.6 crore unique investors, you must learn what this indicator means in detail, its calculation and more for an informed trade or investment.

Understanding the Rate of Change in the Stock Market

It is a technical momentum indicator that traders or investors use to measure the percentage change in asset prices, and it also helps calculate the speed or rate at which a stock or asset price is rising or falling.

Thus, a rate of change helps you understand how strong a current trend in the asset price is and its steepness.

For momentum measurement of an asset price, it considers the current closing price of an asset. It then compares this price with the closing price of that same asset from a time period in a past timeframe, i.e. the look-back period, which a trader or investor sets.

While measuring the momentum, it focuses on a central zero line. Being an oscillator, the Rate of Change (ROC) fluctuates above zero, which signifies that the asset price is gaining strength and moving upwards.

Conversely, the ROC below zero signals that the selling price is increasing and therefore, the asset price is weakening. To arrive at the rate of price changes, it considers how steep the slope of an ROC line is. Here, the steeper a slope is, the faster the asset price moves in that direction.

Suppose for a 12-day look-back period, a stock price moves from INR 100 to INR 180 in 12 trading days. Here, the resulting ROC line will create a steep slope, indicating a rapid price acceleration.

Extreme output, i.e. far from the central zero line, acts as a reversal signal. An extreme ROC reading far from the central zero line often signals that the market might be overextended. It portrays an overbought or an oversold condition that might occur due to a pause in the trend.

A Detailed Process of Calculating the Rate of Change Indicator?

Now that you have an idea about what is ROC in stock market, you must also have an idea of how to calculate it. Here is a detailed view of its calculation with its formula or equation for the rate of change:

Depending on the current asset price and its price in a past or a look-back period, you calculate the rate of change using the formula, i.e. ROC = {(Current closing price of an asset − closing price of it ‘n’ periods ago) / closing price ‘n’ periods ago} * 100.

Here, the current closing price of the asset means the updated price of an asset at the end of the trading day you are calculating the ROC. The closing price of its ‘n’ period ago means its closing price during a look-back period. Here, the ‘n’ represents the look-back period, which is typically 12 to 14.

For further clarification of this calculation, let us use this formula for a hypothetical ROC evaluation. Suppose a stock closes today at INR 1500. Now, you need a 12-day ROC to see at which rate the price has moved. Suppose, 12 days ago, the price closed at INR 1300.

Let us put this information into the above formula to arrive at an ROC:

ROC = {(INR 1500 – INR 1300)/ INR 1300} * 100

= {INR 200/ INR 1300}*100

= 15

As per the above example, the asset price has increased over the 12-day look-back period. Its respective ROC value is 15. This value, generated using the equation for rate of change, indicates that the price has increased by 15% over the 12-day look-back period.

How to interpret a Rate of Change indicator?

After understanding what is rate of change in stock market and its calculation, you must know how to interpret it. A meaningful interpretation of it might help you make an informed investment or trading decision:

1.     The ROC Magnitude

The magnitude of the value of an ROC against an asset price indicates the intensity of price changes. Thus, it helps you assess the strength of the momentum an asset price gained over a set period. Higher values or magnitudes of ROC typically indicate a faster and more significant price movement.

For example, a higher positive ROC represents a bullish price move, and a significant ROC move indicates a bearish price momentum. While a declining ROC usually signals a price momentum which is weakening, and that means a probable trend reversal might be near.

2.     Zero-Line Crossover

A move of a rate of change line from below zero to beyond zero usually indicates a buying indication. While its move from beyond zero to below the zero line indicates a potential opportunity for selling. Suppose the ROC of an asset is at 3% below zero. It then moves above the zero line as the price rises from INR 100 to INR 103, indicating a potential buy.

Later, if the ROC moves back by 3% above the zero line to below zero as the price decreases from INR 103 to INR 100. It indicates a weakening price momentum or a bearish move.

3.     Zones of Overbuy or Oversell

Suppose a rate of change for an asset moves upwards significantly and reaches its highest level. For example, it reaches +15 or any other positive value. Contrarily, if the ROC value is too low, such as -15 or a much lower value, it signals the asset might be oversold, and therefore a reversal might occur.

4.     A Slowdown in Momentum

Suppose you are tracking a stock or an asset, and see its price rising. However, you also notice that the ROC line is starting to appear flat or even dropping, although it is still above the zero line. The rate of change as an indicator suggests that a price uptrend might be losing its momentum.

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Limitations of a Rate of Change Indicator

Although the rate of change has the capability of showcasing price momentum, it also comes with a few limitations. As an investor, you must stay aware of such limitations to steer clear of making wrong investment decisions:

1.     Generation of Wrong Signals

Especially during a consolidated or sideways market, an ROC line might fluctuate around zero. Thus, for an investor, it might appear as frequent signals for buying or selling, which is, in fact, false. It might lead to an entry or an exit at the wrong time.

2.     Absence of an Absolute Threshold

While using ROC as an indicator, you must note that it does not come with an absolute or an agreed-upon level of overbought or oversold threshold. Thus, its interpretation relies upon the asset type you are observing, market conditions, etc.

Conclusion

A rate of change applicable in the stock market trades acts as a tool to assess the price momentum of stocks or other sorts of assets it supports. Placing the current closing price of an asset and its price of ‘n’ periods earlier into a formula, it determines how much prices have changed over that period.

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FAQ’s on Rate of Change

1.     How does the Rate of Change indicator work?

A rate of change indicator uses the current closing price of an asset and its closing price in a user-defined loop-back period. It then uses a formula, i.e. ROC = {(Current closing price of an asset − closing price of it ‘n’ periods ago) / closing price ‘n’ periods ago} * 100 and provides a value.

2.     What does a positive Rate of Change value indicate?

A positive ROC value typically denotes that a price is moving upward and hence indicates a potential bullish momentum.

3.     What is ROC divergence in trading?

Divergence in trading generally appears before a potential reversal. Thus, when a certain asset price is making a new high, yet the ROC falls, it signifies a bearish divergence.  Conversely, when an asset price makes a new low, but its ROC rises, it is a bullish divergence.

4.     What is the difference between Rate of Change and RSI?

One key difference between an RSI and ROC is that the former combines price changes in both upward and downward moves. While the latter concentrates on the current closing price and compares it with the closing price from a look-back period.