How to Measure Volatility of a Security Using Beta
Not often used by day traders, beta comes from the Capital Assets Pricing Model, which is an equation used in academic circles to model the market performance of stocks, bonds, and commodities.
In statistical terms, beta is the covariance (that is, the statistical measure of how much two variables move together) of a stock relative to the rest of the market. Traders don’t use the Capital Assets Pricing Model, but they often talk about beta to evaluate the volatility of stocks and options.
What does beta mean?
A beta of one means that the security moves at a faster rate than the market. You would buy high betas if you think the market is going up but not if the market is going down.
A beta of less than one means that the security moves more slowly than the market — a good thing if you want less risk than the market.
A beta of exactly one means that the security moves at the same rate as the market.
A negative beta means that the security moves in the opposite direction of the market. The easiest way to get a negative beta security is to short (borrow and then sell) a positive beta security.
Most day traders prefer volatile securities, because that creates more opportunities to make a profit in a short time. The volatility of a stock, bond, or commodity is a measure of how much that security tends to go up or down in a given time period. The more volatile the security, the more the price fluctuates.
But volatility can make gauging market sentiment tougher. If a security is volatile, the mood can change quickly. What looked like a profit opportunity at the market open may be gone by lunchtime — and back again before the close.