One of the most popular risk metrics to factor into an investment is the Beta. Beta in trading is a statistical measure used by traders to determine the risk profile of an investment. Through this trading guide, we’re going to discuss different beta option forex trading strategies that a lot of FX hedge funds use on Wall Street.
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Traders familiar with advanced concepts, know that beta can help investors gauge stock’s volatility in relation to the overall market volatility. However, in the Forex market, beta risk metric is not commonly used in a traditional sense.
To understand how beta works in the Forex market, you need to understand how stock traders use the beta coefficient to pick stocks that are moving differently than the overall market average.
Trading is like a business, and like with any type of business, you need to be prepared.
So, how can you prepare?
How can you use beta trading strategies to become a professional trader?
The first step if you want to bring your trading to the next level is to sharpen up your knowledge.
In this article, we will take the time to tackle more advanced concepts like, what is Beta in trading?
Learn the key financial ratios you must look at before making a stock trade: Fundamental Analysis of Stocks – 5 Financial Ratios to Follow.
What is Beta in Trading?
What is beta in stock trading? Beta first originated in stock trading as a means to measure the general risk of our stock positions.
Traders have used the technique known as beta weighting to compare the volatility of a stock to an index.
In other words, beta measures the stock historic volatility relative to a market benchmark, like the S&P 500.
To use a bit of market jargon, the benchmark S&P 500 is used as a beta factor. Here is a list of the highest 100 Beta Stocks.
Now, the S&P 500 has a beta of 1, as it’s considered to be a substitute for the overall stock market.
Here is how to use beta in stock trading:
Forex example: If a stock has a beta of 2 it means that it’s twice as volatile as the overall stock market (S&P 500).
On the other hand, if a stock has a beta of less than 1, it means that historically the stock has been less volatile than the overall stock market.
If you think about it, it makes sense.
The Beta coefficient ranks stocks according to how much they diverged from the overall stock market.
Learning how to calculate the beta coefficient is very simple:
Beta (x) = Slope of stock x / Slope of market average
Let’s take another example and put the beta coefficient formula to the test.
Your preferred stock raises in value by 20% and at the same time, the overall stock market as measured by the S&P 500 performance only increases by 10%.
Can you guess what the beta coefficient for your stock is?
If your answer is 2, you’re correct.
The stock’s beta would be 2, if you use the equity beta formula (Slope of stock x/Slope of market average = 20%/10% = 2).
This means the stock price is twice as volatile as the market average.
In options trading, the higher the beta option trade is, the more volatile the stock is.
But, using beta in forex is a little bit more complicated.
Let me explain further...
It doesn’t make sense to rank one currency to the slope of the market average.
Unlike stocks which possess inherently upwards bias, currencies are traded one against another one.
So, there is no such thing as beta in Forex the same way it can be found in stock trading. You may also be interested in this Free Forex Market Simulator.
In the Forex market, the process of buying and selling always involves buying once currency and at the same time selling another currency.
We’re going to reveal one trick that professional traders use to measure beta in the FX market.
But for now, let’s see…
The second most important investing concept that is often used when investors talk about beta is the alpha coefficient.
Let’s see what’s the difference between alpha vs beta in trading.
Alpha vs Beta in Trading - What's the Difference?
Alpha and beta are two of the most fundamental risk metrics used to measure how portfolio managers perform compared to the overall market average.
So, what is alpha? Up until now, we spend most of our time on the main topic of this guide which is the beta trading strategy.
In finance, Alpha measures the excess return on a particular stock over a relevant benchmark index.
In its most popular understanding, alpha measures if a portfolio manager has managed to outperform the benchmark stock index.
So, what’s the difference between alpha vs beta?
Simply put, beta measures relative volatility risk while alpha measures relative performance compared to a benchmark index.
In the next section, you'll how to use Beta in trading to make better trades.
How to Use Beta in Trading?
We’re going to continue with the theory and explain in more depth how the beta coefficient can help you in your trading. Here is what you need to know:
- Stocks with a higher beta coefficient offer a greater level of diversification.
- Stocks with lower beta coefficient offer a little level of diversification.
So, the lesson here is…
You can use the beta coefficient when you construct your stock portfolio. Beta is a great tool to reduce volatility and design a more diversified stock portfolio.
In theory, low beta stocks will generate lower returns because they are less volatile. It’s very unlikely for low beta stocks to outperform the benchmark S&P 500.
By contrast, high beta stocks can potentially outperform the benchmark S&P 500. However, high beta stocks are riskier. Click here to learn about the best forex trading strategies.
Some stock investors are more than willing to take on that extra risk for potentially generating a higher return.
The bottom line is this:
The first advantage of knowing the beta of your stock is that it will give you an assessment of the stock’s risk.
Secondly, you can apply beta to your stock picks. Learn how to pick stocks with Best Growth Stock Investing Strategy.
Let’s now jump and see how to use beta to construct a stock portfolio.
When to Use Beta Trading Strategy
If you’re a trader that doesn’t like to take a lot of risk you can use a simple beta trading strategy.
For example, if you want to construct a stock portfolio you need to find stocks with lower beta.
In theory, beta varies across different stock maker sectors.
For example, utility stocks have a low beta, while most high-tech stocks have a high beta.
High beta stocks also offer a better risk to reward ratios.
Now, risk-averse investors might gravitate to low beta stocks.
Your stock portfolio can include utility stocks, gas, crude oil, electricity, and dividend-paying stocks.
These stocks can have a beta of less than 1.
For our example, let’s assume that the beta value of our entire portfolio is 0.5.
At this point, if the market moves $10, your portfolio will only move up by $5.
So, what we’re looking at is a stock portfolio that is less risky.
While your returns are capped on the upside, you’re well-protected in case of a stock market crash. Read more about the Best Swing Trading Strategies here.
If you want consistent returns and don’t want to have a heart attack when the stock market crashes, low beta stocks are the way to go.
For example, if you have a beta weighted portfolio of 0.5 and the stock market falls $10 your stock portfolio should only lose half of the overall market movement.
Another profitable beta trading strategy is to pick stocks with positive beta and with negative beta in a way that they offset each other.
For example, if you select a stock with a beta of 2 and another stock with a beta of -2, they might cancel each other.
In this situation your portfolio kind of stays neutral.
But then you may ask yourself, how you profit from such a situation?
This works with dividend stocks and you’re only looking to collect the dividends and keep your portfolio stable and neutral.
These are just some simple ways how to use beta in trading.
Now let’s see how beta option forex trading works.
Beta Trading Strategy in Forex
In this section, you'll learn how to find a way to calculate beta for currency pairs.
In other words, we want to measure how currencies relate to each other in terms of volatility.
In stock trading, we have the benchmark stock index S&P 500.
But, in forex trading, we don’t have a benchmark or beta.
For example, if you go long EUR/USD, you’re simultaneously buying the EUR and selling the USD.
You may ask yourself, how to measure beta in Forex?
We need a different method to measure beta for currencies than how we do it in the stock market.
Let me explain…
A standard beta trading strategy involves building a market average of currencies adjusted for their dollar values. We then compare these averages by a standard deviation.
Here is the beta formula you can use for currencies:
Beta (EURUSD) = StdDev (EURUSD) / StdDev (market average)
The forex beta option formula will help us find currencies that are more volatile than others. We're looking for currencies outside the standard deviation range.
The same goes for stock trading. High beta currencies are the most volatile, while low beta currencies are the least volatile.
In theory, beta option forex trading only seeks to capture the return of the market compared to alpha trading strategies that seek to beat the market.
In the forex market, the rate of return for holding currencies is given by interest rates and interest rate differentials.
Forex traders take advantage of the difference in interest rates between currencies using the carry trade strategy.
Learn here more why investors are attracted to high yielding currencies here: Best Carry Trade Strategy – The $14 Trillion Trade.
If we purely focus on the carry trade strategy, we can build a market average by ranking currencies based on their interest rate differentials.
After we built the generic carry model, we can then compare it against the return of an FX fund index like Eurekahedge.
This enables us to beta weight our FX portfolio’s volatility and performance relative to the broad FX market.
Final Words – Beta Option Forex Trading Strategy
The bottom line is that using beta in trading can help investors calculate their best risk to reward ratio for their stock and FX portfolios. The beta regression analysis is often used to help investors pick stocks that are more in line with their risk appetite level.
Generally speaking, if you want a stock that has the potential to make you bigger profits and in a short time, then you want to pick a high beta stock. Conversely, if you’re risk-averse and want more stable returns, you would want to pick low beta stocks. The same is true with any other type of financial instrument.
A beta trading strategy can be best applied in the Forex market by building carry trade models or trend trading models because it seems they capture a lot of what most currency hedge funds do. Be sure to check our this Forex Compounding Calculator to help you with trades.
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