Beta is an important metric that traders should be aware of. This article will help you develop an understanding of how to use beta options to trade options.
Measuring beta is extremely important as one way or another an investor is using beta in his or her Portfolio.
This article will help understand what beta is and give an example of how it can be used to trade options.
There are many metrics that will help investors understand and risk volatility. One of the most common is beta.
Stocks have both idiosyncratic risk (specific to themselves as a company) and systematic risk (specific to the market).
Take the example of an investor who puts all of their money in Boeing stock. This investor takes on the idiosyncratic risk.
Boeing planes could crash or an investigation could reveal faulty equipment causing recalls. All of these are Boeing-specific risks.
But Boeing also harbors systematic risks. For example, the Covid pandemic had nothing to do with Boeing itself, it hit them Particularly hard bearing, along with the majority of the market.
It’s easy to diversify against idiosyncratic risk.
For example, an investor in the S&P 500 would have already diversified most of their idiosyncratic risk away from Boeing’s faulty aircraft.
After all, what makes a company when you’re invested in 500? Even so, this index investor still has a lot of risk in their portfolio.
This is the systematic risk, or beta.
Beta is the systematic risk of a security or portfolio versus that of the market. The market portfolio, usually the S&P 500, is assigned a beta of 1 as a benchmark.
Beta from 1: Stock moves in line with the market (example: SPY increased by 1%, FB increased by 1%)
Greater than 0 but less than 1: Stock moves with the market, but less than the market (example: SPY up 1%, MCD up 0.5%)
Beta of more than 1: The share moves faster than the market (example: SPY up 1%, AMD up 3%)
Based on our beta, we can predict that high beta stocks will outperform low beta stocks in bull markets and that the same high beta stocks will underperform in bear markets.
This is a reasonable predictor, but not perfect due to the problems inherent with the beta.
First, beta is backward, which is limiting as companies, economic regimes, and crises change.
Beta also assumes that volatility is the same in both directions. As a smart investor, these limitations should not be overlooked.
Even so, calculations or formulas often have flaws.
As we’ll see later in our example, the beta has both utility and limitations.
As an options trader, beta is a particularly useful metric.
This is because we are making trades based on how much we think the stock will move, or implied volatility.
By comparing the implied volatility to the beta, we can tell whether that volatility is low or high.
Using Options Beta as a signal
Let’s say we want to trade options on AMD (a large semiconductor company). Below I’ve plotted AMD’s returns versus the S&P 500.
Here we see that AMD has a beta of 2.8. That means that for every 1% move in the S&P 500, AMD would move 2.8% on average.
The first thing to note is that this beta is simply a best-fit line.
We cannot guarantee that if the S&P 500 climbs 1%, AMD will rise 2.8%. It could even go under! Even so, it works as a reasonable estimate of the rate of return.
Below I’ve plotted AMD’s 90-day implied volatilities divided by the S&P 500. We can see that the ratio fluctuates but is always above one.
Of course, AMD will imply more volatility and typically move more than the S&P 500. After all, it’s a semiconductor company against 500 stocks.
I also drew our 2.8 beta line in red.
What do we notice? Well, we can see that the volatilities are largely floating around AMD’s beta of the red line.
The yellow circles could represent times when the ratio was close to its extremes.
Yellow circles above the line could be times when AMD’s volatility is expensive compared to the S&P, and below the line when AMD’s volatility is cheap.
We can see that the volatility has turned back every time, resulting in profitable trades.
So what on earth is going on in the blue circle !! This is an example of how the relationship between beta and implied volatility breaks down.
It is also accurate during the COVID pandemic. Why should this happen?
During the COVID pandemic, certain sectors were disproportionately affected.
Others like technology and semiconductors (like AMD), which are usually much more volatile, have become almost defensive games.
This was thanks to staying at home and working from home. Combine that with an increase in the index implied correlation during bear markets (a topic for another article) and it’s not pretty!
If a stock’s beta is very different from that of the index or other correlated stock, it could indicate a great trading opportunity, although most of the time there is a reason for it.
Understanding the “why” can help differentiate a good trader from the average trader.
This is just one example of using Beta as an options trader.
There are many others. For example, in the example above, the placement of the trade could involve a relative value game where we buy, say, volatility a straddle on the undervalued asset while sell a straddle on the overrated.
In this case, there would be no point in simply buying the same notional amount of volatility on one and selling it on the other.
It may be better to weight the assets in a beta phase. We know one asset is likely to move more than the other, so using beta-sized positions is one way to trade them.
Best of Options Trading IQ
Beta provides a good measure of the systematic risk of a stock versus that of an index.
As an options trader, it also offers a unique measure of volatility that can be used as a comparison with other metrics.
While it is not perfect as it is not an indicator, it can be used in conjunction with others as a tool to assess trades and market risk.
Disclaimer: The information above is for For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.