Utilizing Beta Values to Calculate Risk in the Stock Market

by Aron Vaxen

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Introduction

Analysis of the stock market could be as detailed as you want it to be. While some just ride on the market sentiment, some prefer performing in-depth studies to draw more promising conclusions. Beta trading is one such technique for analysing the stock’s performance.

Here is everything you need to know about beta trading explained in detail.

What is Beta?

Beta is the numerical value that measures how volatile the returns from a stock could be when compared to the market volatility. An investor uses it as an indicator to measure how risky a share is.

All share markets have corresponding stock beta, which you can assess by analysing a company’s past stock performance, stock volatility and the company’s strength. Many investment managers and analysts use this theory to ascertain the performance of a stock.

How to compute Beta Value?

You can calculate Beta by dividing the covariance of a stock with a dedicated benchmark index by the variance of the stock over a time period.

For example:

XYZ Ltd’s correlation over 5 years with the Sensex Index has been 0.70. The standard deviation of the returns of XYZ Ltd over the years has been 37%, and the standard deviation of Sensex is 21%. The Beta will be as follows:

???? = 0.70(0.37/0.21) = 1.23

Therefore, since ????>1, it has better performance than Sensex, i.e., you can consider it an aggressive and risky stock.

5 categories of Beta Value and how to interpret it

There are five types of beta values that help understand the risks involved in the stocks.

1. ???? >1

If a stock’s beta value is greater than 1, it has low stability. Such a stock is called an aggressive stock. If you invest in such stocks, remember that they are usually very risky but give high returns. Small and mid-cap companies mostly issue such stock.

1. ???? <1 > 0

If the beta value of a stock is less than 1, it means that it is less volatile and follows the market conditions. These stocks, classified as defensive stocks, are less risky.

If you are looking for stable investments but not-so-high returns, you can opt for stocks with a beta value of less than 1. These stocks are perfect for you if you have a low-risk appetite.

1. ???? =1

If the beta value of a stock is equal to 1, it means that the stock market and the stocks are perfectly correlated.

Thus, these stocks will also fall if the market falls and vice versa. Large-cap companies typically have a beta value of 1. These stocks are the most stable ones available in the Indian stock market.

1. ???? = 0

If the beta value is 0, the stock and the market are not correlated. Typically, stocks do not fall under this category, but other securities do.

For example, gold, government bonds, etc., whose value does not depend on the stock market, have a beta value of 0. These securities could act as a hedge for your investments if the stock market crashes.

1. ???? < 0

If the beta value is less than 0, the stock will likely move in the opposite direction from the market. So the stocks will rise, in the bear market, and it will fall in the bull market.

Conclusion

While beta trading can be beneficial in understanding the performance of the stock, there are some things you should keep in mind.

Beta trading does not determine the performance of the company. You can leverage beta trading efficiently if you avoid investing in low-value stocks solely because of their beta value.

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