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Anyone who runs a marathon knows that momentum matters. It matters a lot because the sheer force of momentum can carry runners further than expected.
Similarly, momentum in prices can stretch a stock beyond what is ‘reasonably’ valued. With great momentum, a stock can go up 10x – the proverbial ten bagger! – within a short space of time.
But what exactly is momentum? In markets, price momentum is intricately linked to the rate-of-change (ROC) concept. it measures how fast or slow prices are changing. For example, a one-day ROC takes the 1-day change in prices, while a 10-day ROC is the price difference over ten days.
Consider this monotonically increasing price sequence:
Each step is $10 higher. In dollar term, the 1-day ROC is $10. (Note: in percentage term, the rate of change is dropping.) If you reverse the sequence, then the ROC becomes a negative -$10 as prices drop by this amount per step.
Of course, you can increase the parameter (which we talked about two weeks back) to 10 days, meaning you take the price difference of prices now against ten days ago – and roll this price difference forward.
But how does one use the ROC/momentum? Broadly speaking, the ROC indicator is used to detect a general change in price movements and the price trend. For example, if a stock’s ROC is $10 for some time and this increase drops to $5, $3, $1 – you know immediately that the uptrend is losing momentum. It is vulnerable to a correction.
On the flip side, if a stock’s ROC is -$10, then rises to -$5, -$3, -$1, you’ll see the downtrend is losing momentum and a rebound is possible.
Using Rate of Change to Detect a Trend Change
We show an example of ROC time series with the FTSE 100 Index. To compute the ROC. I take the price difference to be 10 days (bottom chart).
One immediate observation is that FTSE 100’s ROC behaves rather rhythmically. This is a byproduct of FTSE 100’s steady rally post Brexit referendum. The ROC indicator swings to and fro around zero.
But things get far more interesting as the ROC jumps outside its normal range. For example. during February’s correction FTSE’s ROC slumped to its lowest level in many years. But a subsequent retest of its January lows (lower low) was not accompanied by a lower ROC.
This non-confirmation is marked by bold coloured lines in the chart. Soon enough, prices rebounded strongly for a few weeks. The FTSE 100 rallied a thousand points during Mar-Apr.
This is to say, while the FTSE 100 index was hovering near its multi-month lows, its downside momentum is actually contracting. This is a classic example of a ‘bullish divergence’.
Practical Applications of Momentum
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- The ROC is just the price difference between two points in time. You can use dollar-ROC or percentage ROC. But given this simplicity, you must recognise its limitations as a momentum measure.
- You can, however, improve upon the basic ROC by:
- Combining different ROCs together – say, average the 20, 50, 100-day ROCs
- Pair ROC with other indicators – such as the moving average
- Set further conditions on the ROC – say, the indicator must rise/fall to x-level before you would consider using it
- Vary the ROC calculations
- From my experience, ROC/Momentum indicators appear to work better on the downside than the upside. This is to say, momentum indicators detect non-confirmation better after a strong decline.
- Lastly, the ROC does not give signals every day. Its usefulness lies in non-confirmation of trend assertions, which takes place over many weeks or months.
In a nutshell, the ROC is a useful indicator for measuring price momentum. But to use this indicator effectively, you will need to backtest – or at least visually inspect – its behaviour over many instruments across a period of time. Personalise the ROC configuration to compliment your other favourite indicators. Keep practicing on this indicator until you’re comfortable with it – and know when to use it.
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Jackson has over 10 years experience as a financial analyst. Previously a director of Stockcube Research as head of Investors Intelligence providing market timing advice and research to some of the world largest institutions and hedge funds.
Expertise: Global macroeconomic investment strategy, statistical backtesting, asset allocation, and cross-asset research.
Jackson has a PhD in Finance from Durham University.