As many day traders are attracted to relatively volatile stocks, their beta value can often provide a fascinating insight into the future. A stock's beta measures the share price volatility/market risk compared to other indexes or even stocks. While many traders look towards more "modern" complicated technical trading strategies, a simple measure of historical volatility can be very useful.
What is the beta?
When measuring the stock beta compared to an underlying index, the underlying index beta will be one. The stock beta calculated using regression analysis (historical data) will indicate future expected price movement comparisons. There are three factors to consider:-
• A stock beta of less than one means the stock is less volatile than the overall market
• A stock beta of one indicates a stock which will move in line with the market
• A stock beta of more than one suggests a stock which is more volatile than the market
Many websites now publish the beta of constituent stocks against a particular index, which is very helpful for short-term/day traders. So how does this translate into profitability?
Risk/reward ratio
As ever, everything in relation to stock market trading comes down to the risk/reward ratio. The higher the risk, the higher the reward required to justify the greater risk. This is where beta comes into play.
If a stock has a beta of 0.5%, this means that for every 10% movement in the underlying market, the stock price will only move by 5%. Remember, this is on the upside and downside, so a low beta stock can be helpful (at least in relative terms) in challenging market conditions but will hold you back in bullish markets.
Whereas stock with a beta of 1.5, this means that for every 10% movement in the underlying market, the stock price will move by 15%. While very useful on the upside, this does not bode well for those looking to buy stock with downside risk. However, if you can short a stock before a downward movement by the market, then you have the potential to increase your returns by 50% over and above the market fall.
A stock with a beta of one, i.e. one that follows the market, is unlikely to catch traders' attention, as they require a degree of volatility to maximise their returns. However, investing in a par beta stock can be invaluable for tracking the index if you have a long-term upbeat view of a particular stock market. However, there is a note of caution; beta measurements for individual stocks, indexes and overall markets will change over time.
Examples of beta in practice
While we highlighted the example of a stock beta compared to an index, this measure of volatility can be used in many different scenarios. You can:-
• Compare the beta of two stocks against each other
• Measure the volatility of different indexes compared to each other
• Compare the volatility of individual stocks against a broader index
• Measure the volatility of sub-sectors against the primary market
There are some other examples of beta measurements which attract a degree of controversy and differing opinions:-
A beta less than zero indicates an inverse relationship with the market
If a stock has an inverse relationship with the market, thenwhy is it listed on the market in the first place? On the flip side, many experts would point out that gold, often seen as a hedge against economic volatility, is a prime example of a negative beta commodity. This is because gold tends to move inversely compared to worldwide stock markets.
A beta of more than 100
This indicates a stock which has volatility more than 100 times that of the underlying market to which it is compared. In theory, possible, in practice, impossible. Why? A stock with a beta of more than 100 would benefit from the upside, but any downside movement would result in a fall to 0. Putting this into perspective, the maximum beta of established companies is unlikely to be more than four.
Technical trading and charges
Many day traders use technical trading to take advantage of perceived volatility to increase returns. Our competitive charging structure, together with cutting-edge dealing facilities, ensures we can maximise returns on often slim margins.