Alan Hull Articles

The 'Rate of Return' Indicator

Delving into the world of custom indicators can mean chaos on a grand scale or it can make charting a much easier and more rewarding undertaking. One way of avoiding the Chaos scenario is to apply the Problem - Solution approach. Hence, the process of designing a custom indicator should always start with a clearly defined problem.

Problem => how do we compare the profitability of different trading opportunities?

Measuring a shares Rate of change in price with respect to time answers this problem. We can calculate a share's Annual rate of return, given its current rate of climb and its current share price. This is achieved by measuring the annual Change in price and dividing it by the current share price. The result is then multiplied by 100 to convert it to a percentage.

Example:
• Lets assume that a share is climbing at a rate of $2 per year.
• The current price of the share is $5.
• The annual 'Rate of Return' would be 0.4 ($2 divided by $5).
• Converting this to a percentage we get 0.4 x 100 = 40%

Therefore, based on the current trend and the current share price, the annual rate of return is 40%.

Now let's apply this theory to the real world... consider the following chart of IDT. At the beginning of August 1999 the share price was 60¢ and at the end of February 2000 it was $2.10. The line covers a time span of 7 months, during which time the share price rose $1.50.

Now consider the following chart of Suncorp Metway. At the beginning of November 2000 the share price was $10.00 and at the end of March 2001 it was $12.00. The line covers a time span of 5 months, during which time the share price rose $2.00.

Both of these shares are obviously in an uptrend and on the face of it SME appears to have performed better than IDT, given that its share price rose $2.00 in 5 months while IDT's share price only rose $1.50 over 7 months. But in fact the trend in IDT was far more profitable because there was a greater proportional increase in the share price over time. To see this we have to analyse the proportional change in price rather than the actual change in price.

Proportional increase in the share price of IDT
• Assume that you bought IDT at 60 cents at the start of August 1999.
• 7 months later the share price has risen to $2.10, being an increase of $1.50
• Therefore the proportional increase on 60 cents is 1.50 ÷ 0.60 = 2.5
• Converting 2.5 to a percentage we get 250%
  Therefore the share price rose 250% in 7 months.

Proportional increase in the share price of Suncorp Metway
• Assume that you bought SME at $10.00 at the start of November 2000.
• 5 months later the share price has risen to $12.00, being an increase of $2.00
• Therefore the proportional increase on $10.00 is 2.00 ÷ 10.00 = 0.2
• Converting 0.2 to a percentage we get 20%
  Therefore the share price rose 20% in 5 months.

The lesson here is that we must look at the proportional change in price if we are to compare the profitability of upward trends in different shares of varying prices. In the same vein, we must also standardise the time frame, which we are using or we will suffer further distortions in our results.

Converting the previous results to annual figures we get -
• 250% in 7 Months is equal to 429% per annum (250 x 12 ÷ 7)
• 20% in 5 Months is equal to 48% per annum (20 x 12 ÷ 5)

At this point we are almost comparing apples with apples. The annual figures given above are the annual Rates of return for IDT and SME based on the beginning of their respective trends. We now have to accept the reality that we can't travel back in time. IDT's annual rate of return of 429% only applies to us if we had bought shares in IDT at 60 cents in August 1999. Let's take another look at the chart of IDT.

The reality, using our example of IDT, is that we can only buy IDT using the price on the right hand edge of chart. This higher purchase price will have a negative affect on our annual rate of return.

• Increase in the price of IDT over the previous 7 months is $1.50
• Proportional change in price over 7 months, using $2.20 is 1.50 ÷ 2.20 = 0.68
• Converting to a percentage we get 68%
• Converting to an annual rate of return we get 68 x 12 ÷ 7 = 117%

Therefore, based on the current trend in IDT and the current share price, the annual rate of return that we can expect if the trend remains constant is 117%.

Whenever we measure the rate of return of share prices we must use:
• The proportional increase in share price over time.
• A standardised timeframe for comparison, ie. 1 year
• The current share price as our frame of reference, ie. our expected purchase price

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The trends in both IDT and SME could be defined using a straight line. Unfortunately we will encounter a lot of shares which will be banana shaped like Lang Corp.

If we were to measure the rate of return of Lang Corporation by using the price change over 1 year we would come up with a different answer than if we had only used the price change over the previous 3 Months. To solve this dilemma we must employ a method that is a compromise between these extremes. The following chart of Lang Corporation shows a line of linear regression that is generated using 1 year of price activity. In other words it is a line of best fit over the past 1 year period. It is not necessary to understand the mathematics behind linear regression, but to understand that it is used to define a 'line of best fit' over a given period.

Now that we have a smooth unbroken line that depicts the change in price over the previous 12 Months we can use it to measure the annual rate of return. We can measure the change in price, over a given period, of a 52-week line of linear regression to find the annual rate of return.

• Value of the 52-week line of Linear Regression today = 11.67
• Value of the 52-week line of Linear Regression 6 Months ago = 9.06 (6 Months is a compromise between 3 Months and 1 year.)
• Current share price = 12.37
• Annual rate of return = (11.67 - 9.06) / 12.37 = 0.21
• Annualise and convert to a percentage = 42%

Rate of Return - Indicator

The Rate of Return or RoR indicator can be used to calculate the annual rate of return of shares. The indicator pictured at the bottom of the following chart is based on the method described above. By using an indicator to test and measure the rate of return, we will save a considerable amount of time in not having to perform manual calculations. Imagine the effort involved in performing these calculations, prior to the advent of computers.

The RoR indicator pictured above is returning a figure of 42.43%, which coincides with our manual calculations. Although we can achieve different results by sampling the change in price over different periods, it is only imperative that we adhere to our original concept of rate of return and that we are consistent in our approach. We are interested in comparing different trends rather than trying to come up with a perfect method that gives us perfect answers.

Rate of Return - Searches

Thanks to the RoR indicator, we now have the ability to analyse shares on a comparative basis by simply pressing a button. Price/volume breakout searches point us in the direction of Hot Stocks and are an invaluable tool when it comes to speculative share trading. But they will not identify large capitalisation Blue Chip shares that are trending up gradually over time.

Blue Chip shares are ponderous in nature and we need to employ a totally different method of identifying potential trading opportunities within this fraternity of large capitalisation shares. The RoR indicator answers this need by allowing us to filter out shares that are trending up over time and then compare their profitability. The RoR indicator shown in the following chart has a horizontal line positioned at 25%, which can be used as a cutoff level for performing searches.

Woolworths, pictured above, is currently rising at a rate of 40.54% per annum and would be picked up by a rate of return search with a cutoff level of 25%. Unlike price/volume breakout searches where we would scan the entire market, rate of return searches would be restricted to only Blue Chip shares of interest such as the S&P/ASX200 Index shares for example. Another workable criteria would be to only scan shares that have a market capitalisation of at least 100 Million dollars and good fundamentals; such is the case in the Active Investing strategy.

The key factor for using computers successfully in share trading is to always work from a foundation of need. Success is defined as the ability to take profits from the market and taking profits from the market depends on our ability to interpret price activity, not our ability to use computers nor the price we pay for our software. Computers are a 'Tool of the Trade' and are there to solve our problems and meet our needs. They are a means to an end... not an end within themselves.

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In this article, we have used the RoR indicator to filter out shares that are trending up by at least 25% per annum. We will now refine this 'Filtering' process even further by applying separate Entry and Hold cutoff levels. We will also consider the importance of market liquidity and look at how we can Test and Measure it.

New trends and old trends

Looking at the chart of Lang Corporation we can see that the rate of return is highest at the start of the trend and that the rate of return deteriorates as the trend progresses. Although it is not essential, we want to try and get on board trends while there is still some mileage left in them. In other words, if we set our search criteria at 25% and we were to buy a share with a rate of return of 27% then its rate of return could fall below our criteria of 25% in a very short space of time. We need to set an Entry rate of return that will ensure that we don't buy into a trend that is too tired. The following chart of Lang Corporation shows a second horizontal bar set at 40%.

If we use a rate of return of 40% as a benchmark for buying a share and 25% as the benchmark for holding a share then we will avoid buying into trends that are becoming too tired. The highest price we could have bought into Lang Corporation would have been approximately $8.00, still giving us a decent bite of the cherry. At the current rate of return of 36% we are prepared to keep holding Lang Corporation but we would not be prepared to buy at this point. If the rate of return falls below 25% then we will sell because if our money isn't earning at least 25% per annum then we want to find a better home for it. The rate of return will also fall below 25% if the trend moves sideways for a prolonged period of time, which is another condition that is unacceptable to us. However, note that when Lang Corporation moves sideways in price for nearly four Months in early 2000 the rate of return falls but remains well above 25%. Thus, we are dealing with Blue Chip shares and they will move sideways for several months at a time.

Readymade Market

If we equate Share Trading with running a small business then we are in the enviable position of having both readymade customers and no supply problems. By this I mean that there are always shares available for us to buy and there will always be someone prepared to buy our shares when we're ready to sell. This is absolutely true providing we ensure that the marketplace has plenty of actively involved market participants buying and selling shares. But surprisingly, not all of the top 500 companies, ie. Blue Chip shares, enjoy active trading. Each week shares are bought and sold and the Australian Stock Exchange reports the amount of shares that are turned over as well as the price information.

The number of shares that are bought and sold each week is referred to as the volume of shares traded. Trading volume is listed in the share price tables of all daily newspapers and appears as a histogram at the bottom of price charts. Before buying a share we must check the volume to ensure that there is a good supply of shares for us to purchase and that there are plenty of customers for us to sell to when the time comes for us to do so. The following chart shows a share with plenty of trading volume and it is said to be a share with good liquidity.

Each bar in the volume histogram represents the number of shares which were traded for that particular week. The scale shown on the right hand side has been reduced by a factor of one hundred for practical purposes. This means that we need to multiply the scale by a hundred to calculate the actual number of shares traded. So for the busiest weeks of trading, BHP turned over 800,000 times 100 shares, which equals 80 Million shares.

Although it is trending up at over 25% per annum, Bidvest has very poor liquidity. Note how there are weeks when the price doesn't move at all and when it does move, it does so very rapidly and suddenly. In contrast, BHP's price activity is much more fluid in behaviour.

If we were trying to buy shares in Bidvest we would find that there are a shortage of sellers and when we were ready to sell shares in Bidvest there would probably be a shortage of willing buyers. We would find ourselves in the same situation as a store owner with no customers. Store owners say, Location, location, location and our equivalent catch cry is, Liquidity, liquidity, liquidity. We must ensure that there is plenty of passing trade for our Share Trading business. Once again we must establish a benchmark and it needs to based on, Money flow which is directly proportional to the trading volume. We calculate the money flow or dollar turnover of a share by multiplying the trading volume by the current share price. There are two ways of going about the calculation where one is a shortcut of the other, more valid method. We can either select a single week that we believe to be typical of the shares overall behaviour and use it for our calculations or calculate the cashflow over the past several months. Whilst the second method is superior, it is a time consuming and tedious undertaking. Using our shortcut approach we get:

BHP

Trading volume = 20 Million Price = $20.00 Money flow = $400 Million / Week

Bidvest

Trading volume = 75,900 Price = $2.30 Money flow = $175,000 / Week

BHP's liquidity or money flow is totally acceptable whereas Bidvest's is not. We will set our benchmark for an average week's money flow at approximately $1 Million per week.

The Linear RoR Indicator

The following chart shows the Linear RoR indicator, which is a highly sophisticated version of the RoR indicator. It applies all of the criteria covered in this article as well as testing and measuring the actual rate of return. What's more, it uses a variable approach to calculating the rate of return rather than using a fixed period, as explained in the previous article. By using a variable period we can prevent the indicator from lagging behind current price activity.

The linear RoR indicator makes the whole task of searching for shares much faster and easier by incorporating all of our search criteria into a single, automated indicator. It checks for an annual rate of return equal to or higher than 25% and money flow of at least $10 Million per quarter, ie.13 weeks. It switches itself Off if either of these conditions aren't met or if the price activity moves sideways for a prolonged period of time, ie. 4 months or more. The benchmarks that we have established in this series of articles are not set in stone. Although they may be effective in current market conditions, they will become obsolete in the future when market conditions change. If the market slows down over time then we will have to lower our benchmarks in order to find enough trading opportunities and the opposite applies if we enter a bull market. Realistically, we accept that we'll see periods of both bull and bear markets in the future. It is only the concepts behind the Rate of Return indicator that remain constant.