When we defined the Greeks in a previous article, it included a discussion of the price sensitivity of the option premium as it relates to the underlying equity, time and other factors. One of the rules was that (all other factors being equal) an increase in share volatility will increase an option premium. An equity with greater volatility will be associated with an option premium which generates greater profit but is also associated with higher risk.
One way to measure the volatility or systemic risk (market risk) of a security is to compare it to the market as a whole; the S&P 500 being the most commonly used benchmark. This is known as beta. This number is calculated using a process known as regression analysis wherein the “market” is assigned a number of “1″. Beta is the tendency of a stock’s returns to respond to changes in the market.
– Beta of 1- the equity price will move in conjunction with the market. If the market is up 2%, so will the stock (be expected to).
– Beta of less than 1- the stock will be less volatile than the market. An example would be utility stocks
– Beta greater than 1- the security price will be more volatile than the market. An example would be tech stocks.
If a stock has a beta of 1.5, it is considered 50% more volatile than the S&P 500. If the market appreciates by 8%, the expected return of that equity, based on its beta, would be 12%. On the other hand, if the market declines by 8%, that equity would be expected to decline by 12%. There you have the two faces of enhanced volatility…greater potential returns with enhanced risk. If an equity had a beta of.5 and the market was up 8%, one would expect that security to appreciate by 4%.
A stock with a negative beta tends to move in the opposite direction of the market. An equity with a beta of (-) 2 would decline by 10% if the market appreciated by 5%. It would increase by 10% if the market declined by 5%.
Problems with beta:
There is no such thing as a panacea in the stock market. This ratio does have its flaws and should not be relied upon solely in determining the risk of our investments. Here are the drawbacks:
– Beta does not account for business changes like a new line of products.
– Beta looks backward and history is not always an accurate predictor of future events.
– Beta ignores the price level of a stock.
– Beta makes the assumption that the volatility is equal in both directions.
The drawbacks are more significant for longer term investments. Beta can be extremely useful to us as 1-month covered call investors. For our purposes of selling 1-month call options, beta is a good measure of risk.
Implementing beta into our decision-making process:
High beta stocks will outperform the uptrending stock market and underperform the downtrending market. Low beta equities will underperform the uptrending market and outperform the downtrending market. In a bullish market, I lean towards high beta stocks and sell O-T-M strikes. In a bearish market, I favor low beta stocks and sell I-T-M strikes. In neutral markets, I “ladder” (use a mix) my beta stocks, in much the same way that I “ladder” my strikes.
You can access beta information from several free sites such as:
– Type in ticker on upper left
– Look at left column on next page
– Click on “key statistics”
– Look on right side of next page for beta stats
Beta is simply a tool in our arsenal. Market conditions will dictate whether we should lean towards high or low beta stocks. It should be used in conjunction with all our system criteria. No one factor will make our investment decision evident. By continually throwing the odds in our favor using sound fundamental and technical analysis along with common sense, we will watch our profits rise and our successes dominate our portfolios.