Beta is a statistical measure used by stock analysts to factor the risk of a certain stock in terms of valuation. It determines the volatility of a stock within the market at the current point in time and compares the stock’s movement when compared to a selected benchmark that is thought to represent the market as a whole (often SPDR S&P 500 ETF Trust, trading under the NYSE ticker SPY). As a general rule, beta value’s primary purpose is to provide historical-based data they can use to see how closely an asset has repeated the performance of a major benchmark.
What is a Stock Indicator?
Stock indicators, sometimes referred to as “technical indicators,” are calculations made on the historic price, volume, interest and additional data points related to a specific stock. Traders who use indicators to determine which assets they should buy and sell attempt to use past price trends and current asset movement to predict future price trends and determine when they should exit their trades.
There is no single stock indicator that guarantees that the price of an asset will go up or down. However, when multiple indicators are used in conjunction, they can help a trader create an entry and exit point for an upcoming market movement. Beta value is an example of a stock indicator.
What is a Beta Stock Indicator?
A beta stock indicator is a volatility indicator value that gives you an idea of how an asset is moving when compared to the underlying index that it is tracking. You can use beta data to see if a particular stock is showing more or less volatility as the overall market as a whole.
What Does Beta Tell You?
By definition, the overall stock market or a fund or index that tracks the overall market via the S&P 500 has a value of 1.0. If a stock is showing higher volatility compared to the market. If a stock has a beta value below 1.0, it indicates that the stock is showing less volatility than the underlying index. If a particular stock has a beta value of 1.0, it means that the stock is showing the exact same volatility as the overall market. This is not a common occurrence, even when the stock in question is included within the underlying index.
Let’s take a look at a real example. Imagine that Apple (NASDAQ: AAPL) has a beta value of 0.63. When compared to the underlying index (let’s say SPY to avoid confusion) an investor can extrapolate that AAPL is 63% as volatile as the SPY. This means that if the SPY rises, AAPL stock will move less dramatically.
High beta numbers do not always mean “good.” The only thing that a high beta value tells you is that a stock is performing with exceptionally more volatility than the general market. For example, if a stock has a beta value of 2.0 and the SPY begins to perform poorly, the stock can potentially see a decrease in value that’s twice as dramatic as that seen by the index.
In some rare cases, a stock may have a negative beta indicator. A negative beta indicator means that the stock or asset is showing a direct inverse relationship to the market. You can think of a negative beta value as the mirror image of the trend that a whole number value represents. Put options and inverse ETFs are designed to have negative beta values because they hope to increase in value based on the opposite movement of the market.
How to Calculate Beta
To calculate beta, you must have access to the following values:
- Covariance: The covariance measures the return of a stock when compared to another asset. In most cases, when calculating beta, you’ll use the covariance of the stock you’re interested in calculating and the covariance of SPY. A positive covariance value indicates that assets are likely to move together, while a negative covariance indicates that the assets are likely to move opposite of one another.
- Variance: The variance of a stock measures how far a stock moves relative to its mean.
What’s the difference between covariance and variance? Covariance measures price correlation between 2 individual assets while variance measures the volatility of an individual stock over time.
The formula to calculate beta is as follows:
To calculate a stock’s beta value, you’ll need to divide the stock’s covariance with the underlying index with the variance of the index over time. Let’s take a look at an example.
Imagine that you want to calculate the beta value of AAPL stock in comparison to the SPY index. Using recent 5-year data, Tesla (TSLA) and SPY share a covariance of 0.032, while the variance of the SPY is 0.015. This means that to calculate beta, we need to divide the covariance (0.032) by the variance (0.015), receiving a final beta value of about 2.13. This means, theoretically, Tesla stock over this time period was 113% more volatile than the SPY.
Advantages of a High-Beta Stock
A high beta value indicates that a stock shows increased volatility when compared to the market as a whole. Some investors who focus on making quick daily trades or who only plan to hold assets in their portfolio for a short amount of time frequently look for high beta stocks to compound their returns.
This strategy works most effectively when the stock market as a whole is showing a bullish trend. For example, if a particular asset has a beta value of 2.0, it may return close to 2 times the amount that the S&P 500 returns when measured by percentage. Investors can take advantage of this by investing in low-value assets that show greater price movement when the market moves upward.
Disadvantages of High-Beta Assets
The obvious downside to assets with high beta values is that the market doesn’t always show an upward trend. Just like returns can be compounded when the market is bullish, losses can also compound when the market is bearish. This means that, though high beta stocks have a larger potential to show greater percentage returns, they also have the potential to result in compounded losses as well. This is why very high beta stocks are usually only recommended as short-term investments.
Advantages of a Low-Beta Stock
If you’re searching for a safer investment, it’s usually a better idea to purchase a stock with a lower beta value. A low beta value indicates that the stock shows less overall volatility when compared to the market as a whole. This means that major price fluctuations in the underlying index are felt less severely by the assets with a lower beta value.
Disadvantages of Low-Beta Assets
The disadvantage of investing in assets with a low beta indicator comes during a bull market. Because low beta assets show less volatility when compared to the market, this means that you’ll see only a fraction of the returns that the market index sees when prices are moving upward. These stocks then are usually unsuitable for short-term trading strategies.
Benefits of Beta Stock Indicators
The benefit of beta stock indicators is that they provide you with a way to assess basic volatility risk factors. If you’re looking to build a long-term portfolio, you may want to choose assets with a lower beta factor in order to limit your risk. On the other hand, if you’re looking to take advantage of short-term strategies, high stock volatility may allow you to compound your profits with less of an initial investment.
Best Online Stock Brokers
If you’re interested in learning more about how you can use stock indicators to learn more about the science behind trading, consider opening an account with an online broker. A broker is a financial institution authorized to buy and sell securities on your behalf. The broker that you choose will determine which trading tools you have access to, which assets you can buy and sell and the fees that you’ll pay when you trade. This makes choosing the right broker especially important.
Not sure where to begin comparing brokerage options? Consider starting off with a few recommended service providers for beginners below.
The Value of Beta
Though beta can be considered to be exceptionally valuable when searching for assets that are likely to change in price regularly, it may not be very useful for investors looking to find long-term holds to add to their portfolio. Beta values do not take fundamental analytics into account, which are considered to be another major factor to think about when investing. If you do decide to incorporate beta values into your investing strategy, be sure to use it when executing a short-term trading strategy.
Frequently Asked Questions
What does a beta of 1.5 mean?
An asset with a beta value of 1.5 means that the asset is expected to see a return in value that’s 1.5 times the market return of the index it tracks when comparing percentage growth. For example, imagine that you own 1 stock worth $1 with a beta of 1.5 and that that stock tracks the SPY (which currently has a value of $500 and a beta of 1.0). The SPY increases in value by $5 per share, which represents a positive change of 0.01%. You can expect a stock with a beta of 1.5 originally $1 to now be worth $1.015 (1.5 times the return of the SPY).
What is a good beta score?
The definition of a good beta score varies depending on the context. For example, if you’re looking for a stock to add to your long-term portfolio, you’ll want to look for a lower beta value to limit the possibility of risk. On the other hand, if you’re using a trading strategy that hinges on high volatility (like scalping or day trading), you may want to research assets with higher beta values to increase the chance of return.
About Sarah Horvath
Sarah is an expert in the insurance, investing for retirement and cryptocurrency space.