During your time as a day trader/asset management client, you will undoubtedly have come across the term beta. This is a term used to represent the volatility between, for example, individual stocks and a stock market. While often associated with short-term trading, it is also essential to recognise the value of beta from an asset management point of view.
What is beta?
Beta is a numerical expression of the variation in performance – volatility – between two different assets. For example, if a stock had a beta of one compared to the market on which it was listed, it moves precisely in line with the market. If the beta is less than one, this suggests that the stock will not rise or fall to the same extent as the market. Where the beta is more than one, this indicates the stock moves in line with the market but to a greater extent.
Day traders and beta
One of the central components of a day trader's strategy is volatility. In theory, the more volatile a stock is the more chance of it being overbought and oversold, creating a short-term trading opportunity. Consequently, day traders tend to focus on high-beta stocks, which will outperform stock markets on the upside while underperforming on the downside. Depending upon the facilities available, as a day trader, there may be the option to go long or short on a particular stock.
Asset management and beta
When looking at long-term asset management, knowing the relationship between particular assets and markets is crucial. For example, let us assume that you held equal weightings of the following three stocks:-
• Stock A, beta 0.5
• Stock B, beta 1.0
• Stock C, beta 1.5
While you have a variation in the relationship between the stocks and the underlying market, the average of the three betas is one. This means that, in theory, the portfolio, because of the asset management setup, would be expected to move in line with the market.
If there were a slightly higher weighting towards Stock A, then the average beta would be under one. This means that the market would underperform on the upside but outperform on the downside. On the other hand, if there were a greater weighting towards Stock C, the asset management setup would create the opposite performance.
Remember, beta is historic
Whether looking at beta from an asset management or a day trader perspective, it is essential to realise these figures are historical. They are based on the past performance of the individual assets and the market. No fundamentals are considered, one-off increases or decreases or the underlying economic scenario. However, beta gives you a valuable indication of a stock's potential outperformance and underperformance in relation to the market.
Using beta to measure commodity performance
Even though there is much focus on day traders and using beta to calculate asset management structures, in theory, this practice can be used to measure the correlation between any two assets. They don’t necessarily need to be linked in any shape or form to measure the variation in performance. One typical example is gold, which has a negative beta compared to the stock market. What does this mean?
A negative beta means that the asset in question moves in the opposite direction to the base measure. For example, when looking at the long-term performance of stock markets and gold, you will notice numerous times that there is a negative correlation. While not always correct, we often see periods where the price of gold rises as stock markets fall. This is why gold is often seen as a hedge against inflation or a safe haven in times of market volatility.
Summary
Whether looking at beta from a day trader or an asset management point of view, it can provide a handy correlation indicator, although this is based on historical information. From a day trader's point of view, the higher the beta, the more volatile the stock and the more chance of trading anoverbought or oversold situation. On the other hand, when used in asset management, beta can allow you to adjust portfolios dependent upon, for example, market conditions or the risk profile of a particular client.
While just one of many factors to consider, beta is worth looking at!