Beta is the coefficient of output on regression of the market.
More simply put, beta is a way to measure the underlying’s risk relative to the overall market. For example, a beta of one is about the same level of risk as the overall market. The SP 500 is considered to have a beta of one. A beta lower than one indicates that the underlying is LESS risky compared to the overall market, and a beta greater than one means that the underlying is MORE risky. However, the risk-return tradeoff is something that traders should keep in mind. Taking on more risk offers the opportunity for higher returns. It all depends on where your personal risk preference lies.
So when we beta-weight our portfolio, we are comparing our risk level to that of the larger market. Most traders beta weight to the SPY (SP 500 ETF) but if you have a tech heavy portfolio, you might consider beta-weighting to the NASDAQ, or are energy stock concentrated, you might beta-weight to a large cap energy ETF, etc. It all depends on where your overall risk lies.
To provide an example, consider stock XYZ, a component of the SP 500 with a beta of 1.7. That means that XYZ’s price, on average, has been 1.7 times (or 70%) more volatile than the SP 500. This is a pretty high beta for a stock.
But what if one is bullish on XYZ, but is nervous about the beta level? To hedge some of this risk, one can consider ABC, with a beta of 1, and a 0.70 correlation to XYZ. That means that the movement between XYZ and ABC has been pretty similar over time, and it is highly likely that if XYZ goes up, ABC will too.
Lower beta names like ABC experience less volatility than high beta names (XYZ) during times of economic turmoil, like the Great Recession. A low beta portfolio protects you from potential drawdowns in the market, and saves you from overexposure in volatile stocks in rapidly moving markets.
So, it’s pretty important to pay attention to beta when considering your overall portfolio, and when considering underlyings to trade. It’s best to stick to relatively low beta, especially in times of big market moves. Some high beta trades can be profitable, but once again, it’s a balance of risk and reward.
Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.