In an earlier article, we had studied how the Bollinger Bands can be combined with the RSI to trade pullbacks. This week, let’s take a look at how the Bollinger Bands can be combined with another popular momentum oscillator - ROC(Rate of Change).

Rate of Change (ROC) Indicator

The rate of change indicator (ROC), one of the best-known oscillators in technical analysis. It is an important measure of momentum. It describes the rate at which price changes occur. ROC can be defined as a relative change. It has a high predictive power and it is not surprising that it has become a very popular indicator.

It is calculated as the percentage change in price between now and the price T periods ago.

Formula:

ROC (T periods) = ((Last Price - Price T periods ago)/Price T periods ago) * 100

where, T is the no of periods you can choose. The default is 14 periods.


Trading with ROC

Traders use the ROC crossing above and below zero as bullish and bearish signals respectively. This can be better understood from this figure below.

As you can see the ROC is very capable of producing excellent signals on its own, but you must understand the downsides before using it.

  • It has no natural smoothing. Sudden large moves can cause jerky moves in the indicator.
  • It does not provide any information between time points used — that is, between the present and time point T periods ago — even though the points between two points in the definition may contain important information.

However by combining it with a price or a volatility indicator can help in producing far better results.

Trading System with Bollinger Bands (BB) & Rate of change (ROC)


The philosophy of this trading method is to enter into a long or short position once momentum has been established in that direction.

For a long position, we will use a breakout above the 1 standard deviation of the 20 period EMA, that is the upper band of the Bollinger Band with setting(20,1). We will simultaneously check if the ROC is above zero. These conditions conclusively establish a strong upward momentum.

Both the conditions should be met, hence we use one crossover condition and one higher than condition on the Alert to check for confirmation.

One can trade the short side by setting the opposite conditions discussed. I have detailed out the conditions for both trades below.

If you look at this daily chart of HDFC Bank in the figure, the trading system produced 8 trades.

  • 4 on the long side: 3 winners. 1 loser
  • 4 on the short side: 2 winners. 2 losers
    Also, the profits captured in the winning trades are far higher than the losses when stop losses were hit.

Personally, I have a preference for trading this system on the long side as it gives me good entry points in fundamentally strong stocks as this chart also establishes.

1) Long Entry
A long entry should be made when these conditions are met:

Daily Chart

  • Upper BB (20,1) crosses below Price AND
  • ROC (9) is higher than zero.
    OR
  • Upper BB (20,1) lower than Price AND
  • ROC (9) crosses above zero.

Stop Loss
If ROC crosses below Zero

Target

Trailing stop losses and riding the trend is an effective strategy here. If one wants a quick momentum trade, you can exit if the price falls below upper BB. If you want to continue holding the position, you can hold as long as the ROC stays above zero.

2) Short Entry
A short entry should be made when these conditions are met:

Daily Chart

  • Lower BB (20,1) crosses above Price AND
  • ROC (9) is lower than zero.
    OR
  • Lower BB (20,1) higher than Price AND
  • ROC (9) crosses below zero.

Stop Loss
If ROC crosses above Zero

Target

Trailing stop losses and riding the trend is an effective strategy here. If one wants a quick momentum trade, you can exit if the price rises above lower BB. If you want to continue holding the position, you can hold as long as the ROC stays below zero.

Conclusion
Trading in the past, I have seen that high momentum stocks or commodities tend to outperform low momentum ones over long periods of time. This trading system is well positioned to help you identify these trades and ride the trend.

See you next week.