Rate of change is an oscillator that measures how fast the momentum of the market is changing over the observation period. Rate of change is very similar to momentum in that it compares the current price with the price a specified number of periods ago; however Rate of Change is calculated differently. Where momentum subtracts the current price from the price a specified number of periods ago, Rate of change divides the current price by the price a specified number of periods ago and then multiplies the result by 100.
The most common uses of Rate of Change in Binary Options are to:
- Indicate overbought and oversold conditions
An overbought or oversold market is one where the prices have risen or fallen too far and are there likely to retrace. If the Rate of change line moves to a very high value above the 100 line, this is a sign of an overbought market. If the Rate of Change line moves to a very low value below the 100 line, this is a sign of an oversold market. Overbought and oversold signals are most reliable in a non-trending market where prices are making a series of equal highs and lows.
If the market is trending, then signals in the direction of the trend are likely to be more reliable. For example if prices are in an uptrend, a safer trade entry may be obtained by waiting for prices to pullback giving an oversold signal and then turn up again.
- Indicate Bullish and Bearish Divergence
Divergence between the Rate of Change line and the price indicates that an up or down move is weakening. Bearish Divergence occurs when prices are making higher highs but the Rate of Change is making lower highs. This is a sign that the up move is weakening.
Bullish Divergence occurs when prices are making lower lows but the Rate of Change is making higher lows. This is a sign that the down move is weakening. It is important to note that although Divergences indicate a weakening trend they do not in themselves indicate that the trend has reversed The confirmation or signal that the trend has reversed must come from price action, for example a trend line break.
Observation Period: (default 14)
Normally the Observation Period is set to half the cycle length of the underlying instrument. This means that the Rate of Change line will pea and bottom along with prices. Using a shorter Observation Period increases the responsiveness of the Rate of Change oscillator while also increasing the risk of false signals. Using a longer Observation Period slows the responsiveness of the oscillator to price changes, resulting in late signals.