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Trading rules based on ROC

A negative divergence occurs when the indicator starts falling.

, ET Bureau|
Nov 22, 2019, 09.11 AM IST
The previous edition introduced the momentum indicator rate of change (ROC) its calculation. This edition explores trading rules based on it.

Crossover rule: The ROC indicator moves close to zero. A value above zero indicates that the counter is in an uptrend and a negative value signals that the counter is in a downtrend. As is evident from the crossover chart, an ROC that is going above zero is considered a buy signal (i.e. marked by up arrow in the chart), and if it is falling below zero, it is treated as a sell signal (i.e. marked by down arrow in the chart). This crossover rule works better in trending counters. Traders using this rule usually use a reasonably longer indicator, like 30 days ROC, to avoid frequent buy/sell signals.

Overbought / oversold rule: As explained earlier, the rate of change is designed to move close to zero, and if it moves away from this value, it indicates high momentum in the market. For example, a high ROC indicates frenzied buying and the counter may be in an overbought zone. Similarly, if the ROC falls to very low levels, it indicates heightened selling pressure and the stock may be in an oversold zone. This overbought / oversold rule works well when the counter is facing a sideways movement or when one wants to trade for short durations. Therefore, most traders use 10-day ROC for such trades.

Divergence rule:
As explained earlier, divergent rule is a very powerful one. Divergent happens when the indicator and price move in opposite directions. A negative divergence occurs when the indicator starts falling despite the price moving up. The implication here is evident: though the price is rising, the momentum is weakening and, therefore, the turnaround may be near. A positive divergence occurs in the reverse situations, ie, when the indicator shows higher bottoms even when the price continues to create lower bottoms.

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