Beta, in short, is a measurement of risk a stock or ETF holds against a benchmark index such as the S&P 500. Higher beta usually means bigger movements and visa versa for lower beta stocks or ETFs. Understanding beta can provide your portfolio with a hedging tool and the opportunity for bigger gains (and losses).
Beta, Beta, Beta.
The S&P 500 SPDR (SPY) has a beta of 1, while stocks and ETFs are calculated using an index to compare the correlation. Any beta over 1 means a stock or ETF outperforms its benchmark index. A stock with a beta of 2.0 will usually go up twice the amount of the benchmark that tracks it but also goes down at the same rate. Stocks and ETFs with a negative beta trade inverse to their benchmark index and are useful in hedging long positions.
The more confident you are of a markets direction, the higher beta stocks and ETFs you want in your portfolio. In an uncertain, choppy market, you should stay with lower beta stocks and ETFs or stick to the indexes.
Pairs Trading
When used correctly, beta is an easy way to outperform (and underperform) a benchmark but can also be a tool to hedge your investments. Buying a stock with a higher beta and shorting a lower beta stock is one way to hedge your investments in an upward trending market. In a downward trending market, just reverse the trade selling the high beta stock and buying the lower beta stock.
Things To Remember
- Beta is calculated on past performance.
- Beta can hide negative correlations.
- Beta, alone, should never be used to buy/short any security.
Use beta wisely and always have stop orders.
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