Trading stocks is more of an art than a science. Sure, you need to study the company you are interested in, learn all about its structure, its people, and its future plans, and most certainly scrutinize its public records of losses and profits. But how can you really know whether a particular stock makes for a risky investment or not? That’s when you turn to beta. Beta provides the measure of a stock’s price volatility relative to the volatility of the entire market.
- Don’t waste time calculating beta.
How do you calculate beta? You don’t! Beta is derived through a complex formula that uses regression analysis and can easily be found on many sites on the web with investment information. The beta number calculates the relative volatility of a stock in relation to the entire market.
- Understand that beta measures a stock’s volatility relative to its market.
To understand beta numbers, you must first know that the market beta is always set at 1. A stock beta of 1, therefore means that the stock is expected to show equal volatility to the market. Beware, however, that equal volatility does not necessarily mean that the prices will move up and down together, but only that the degree of their movements will be proportionate, even if opposite. A stock beta of less than 1 means that the stock is set to exhibit less volatility than the rest of the market—and is therefore considered stable—while a beta greater than 1 lets you know that the stock is quite volatile and therefore quite risky.
- Learn the pros and cons of high-beta stocks.
Do not be misled into thinking that any stock with a high beta is a bad investment. High volatility does not only bring higher risk but also higher returns. A high beta, therefore, of a company you monitor and understand well, may signal to you greater trading opportunities. Low volatility, on the other hand, brings not only less risk but also lower returns, which may be good for a long-term trade but not satisfy your short-trade expectations.
- Understand that some markets are naturally more volatile than others.
Another point to keep in mind, moreover, is that a stock’s beta should be compared to the beta numbers of other companies in the same sector for a better understanding of its true value. Technology companies tend to have high betas due to the fast-paced environment in which they operate while utilities companies have low betas, usually below 1.
- Use beta to control your risk.
You should know, moreover, that since beta is calculated using past data, it is not considered a great predictor of future movements, and thus tends to be applied to shorter-term trades that catch the current movements of the market. Any investment, of course, always carries with it a certain amount of risk, regardless of its relative volatility, and you should never trade outside of your risk tolerance level. Use beta to gauge the risk, but always decide based on your personal trading preferences and criteria.