How to Use Beta to Evaluate Stock Risk
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 scrutinise its public records of losses and profits. But how can you really know whether a particular stock makes for a risky investments 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.
How to Read Beta Numbers
How do you calculate beta? You don’t! Beta is derived through a complex formula that uses regression analysis and can be easily found on many sites on the web with investment information. Because the beta calculates the relative volatility of a stock in relation to the entire market, to understand beta numbers you must first know that the market beta is always set at 1. A stock beta of 1 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.
How to Use Beta for Your Trades
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 great 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. 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. 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 a certain about of risk, regardless of its relative volatility, and you should never trade outside of your risk tolerance levels. Use beta to gauge the risk, but always decide based on your personal trading preferences and criteria.