Credit: Shutterstock photoWe're going to discuss beta today, which is sometimes a difficult concept for options traders to get their arms around. Simply put, beta is a a measure of volatility.
Although beta can be calculated in different ways, the beta most people are familiar with is the one that measures a stock's volatility relative to the broad market. A stock with a beta of 1.0 moves historically in sync with the broad market, while a stock with a beta greater than 1.0 tends to be more volatile than the market. Meanwhile, a stock with a beta lower than 1.0 can be expected to rise or fall more slowly than the general market. Beta can also be used to measure the volatility of an individual stock against a specific sector.
Beta and volatility are not the same thing. Volatility, as it is used in options trading, is a measure by which the individual stock is expected to fluctuate over a given period of time. It is the amount by which the underlying stock can change during the life of the option. In options trading, the expected, or implied, volatility, is often measured against actual historic volatility.
Volatility Example: if a stock such as Microsoft has an annual volatility of 40%, then it would be expected to move up or down 40% in price on an annual basis.
Beta Example: if a stock such as Microsoft has a beta 1.26 in relation to the S&P 500 Index ( SPX ), it would be expected to move at a rate of 126% of the fluctuation of the SPX. (This beta is calculated over a period of months and does not necessarily hold true on a daily basis.) The higher the beta, the more volatile the stock. A beta of less than one indicates that the stock's price is more stable than the market (in general and over a long time period).
So how is this useful for the average options trader? Simply, a high beta offers the possibility of a higher rate of return, but also poses more risk. For example, high-tech stocks, as a whole, generally have a higher average beta than 1.0. If you know that the beta for, say, biotech stocks is 1.15 and you found a company in that industry with a beta of 0.8, this would tell you that the company is not only less volatile than the market as a whole, but extremely stable compared to its industry, which could be good or bad depending on whether you are looking for price stability or rapid price growth.
So who uses this beta figure and why do they use it? Portfolio managers and sophisticated traders with large portfolios of stocks use it to hedge their positions. They can either increase or decrease their exposure to the market using the beta calculations. Let's see how this is done using stock futures.
With a stock index future, investors can speculate on the general direction of the market or can buy or sell a contract to hedge their positions. It is also possible to buy options on stock index futures. Unlike stock index futures or index options, futures options are settled by delivery of the underlying stock index futures contract, which will later then settle in cash.
Let's say that a fund manger expects the market to rise and he wants to increase his exposure to the market. How can he best achieve this? He can accomplish that by increasing the quantity the dollars invested in the market, or by increasing the beta of the particular portfolio under his control. The higher the beta, the larger the rise in the value of the portfolio, presuming the market rises as he expects.
Schaeffer's Investment Research Inc. offers real-time option trading services, as well as daily, weekly and monthly newsletters. Please click here to sign up for free newsletters. The SchaeffersResearch.com website provides financial news, education and commentary, plus stock screeners, filters and many other tools. Founder Bernie Schaeffer is the author of the groundbreaking book, The Option Advisor: Wealth-Building Techniques Using Equity & Index Options .
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
