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Rate of Change in Day Trading

The last chapter discussed momentum as a day trader indicator. This chapter will explain how to use rate of change (ROC) as an intraday timing indicator. While momentum is calculated by subtracting 1 day's price from another, rate of change is determined by dividing 1 day's price by another. Therefore, if yesterday's price was $4 and today's price is $2, we would divide $4 by $2 and arrive at a rate of change of $2. In this case, the momentum as well as the rate of change indicator would have a value of two. If yesterday's price was $7 and today's price was $2, then the rate of change for today would be 3.5, or 7 divided by 2. In this case, the momentum, however, would be 5 (2 subtracted from 7). To calculate a 5-day rate of change, simply divide today's price by the price 5 days ago. It's really that simple.

Figure 10-1 illustrates an intraday price chart plotted against a 1-day ROC, a 3-period ROC, and a 14-period ROC. As you can readily see, the length of the ROC you've selected can make a very big difference in the trades you find.

ROC is essentially an oscillator which is sensitive to changes in marВэket movement which allow us to know ahead of time when a change in price trend is likely to occur. However, ROC cannot tell us whether this change will be a large one or a small one. It can only tell us that the trend is likely to change. Knowing that a change in trend is likely, we can, as day traders, take the necessary action to either limit losses or to enter potentially profitable day trades. ROC as well as MOM both apply to position trades as well.

As you can see, the calculation of a one ROC index is extremely simple. To calculate a two ROC, divide the price 2 days ago from today's price.

For calculating 3-, 4-, or 5-day ROC, follow the same procedure. ROC is a rate change indicator, since it provides you with an idea of trend strength. When ROC is moving down very quickly, it is an indication that prices are changing rapidly on the down side with large price moves. When ROC is rising rapidly, it is an indication that the market is trending strongly higher. ROC can be used as a trading indicator by applying some simple rules. This chapter will illustrate some suggested applications of intraday ROC for the purpose of day trading.

Figure 10-1 shows an intraday price chart versus a 21-day ROC indiВэcator. As you can see, ROC is an oscillator. It fluctuates above and below a zero line. When ROC crosses from negative to positive, an uptrend is likely, and when it crosses from positive to negative, a decline is likely. As with most oscillators, ROC is good at finding trends; however, it gives many false signals as it flutters above and below zero.

Regardless of this limitation, ROC can be used very effectively for position and day trading by comparing it to its first derivative. This is a simple procedure. All we need to do is to plot ROC against a moving average of itself (which is its first derivative).

Figure 10-2 shows the same market as Figure 10-1 but with an 18-peri-od MA of the 21-period ROC. As you can see, by buying and selling when ROC crosses above and below its MA line, many of the false start signals are eliminated.

In addition to the use of a moving average of ROC to determine its first derivative, you can use other indicators such as RSI, stochastics, or momentum (discussed in Chapter 9). Figures 10-3 through 10-7 illusВэtrate some of the different derivative methods and their signals as used in day trading. The methods and applications discussed in this chapter hold great promise as timing indicators and trading systems; however, considerably more research must be completed before firm conclusions can be reached.

As you can see, several potentially effective derivatives of the ROC indicator may be used to decrease the number of false signals. The research on these combinations is still very sparse, and I encourage those who are interested in refining their day-trading techniques to investigate these combinations more thoroughly.