Hey Trader,

When markets are as unpredictable as they are today, it’s important to take a good, hard look at your trades, and make sure you’re not taking on any undue risk.

Now, you should always be aware of, and managing, your basic option Greeks … delta, theta, vega, and gamma.

But there’s a fifth Greek that doesn’t get as much time in the spotlight …

But is crucial nonetheless.

I’m talking about beta.

Managing your portfolio’s beta is crucial if you want to make sure you’re not overexposed to the whims of the broader market.

In order to do that, you need to have an understanding of what beta is, and why you don’t want your beta tipping too far in one direction or the other.

So what the heck is beta, anyway?

Beta is a measure of volatility. 

Specifically, beta measures a stock’s volatility as it compares to the volatility of the market – so a stock with a beta of 1 typically moves in sync with the broad market, while a stock with a  beta below one tends to be less volatile, and a beta over 1 indicates the stock is typically more volatile than the market.

If a stock has a beta of 1.5, that indicates it is 50% more volatile than the S&P 500 (Ticker: SPX).

So if the SPX moves 10%, we would expect to see that stock move 15%.

On the other hand, if something has a beta of 0.5, that indicates it is 50% less volatile than the SPX, so with a 10% move in the SPX, we would expect to see the stock in question move only 5%.

An option’s beta is the covariance (a statistical measure of how two variables move together) of the option’s return with the market return, divided by the variance of the market return.

It can be written as:

B = Covariance (Re, Rm)/Variance(Rm)

Where Re = stock return and Rm = market return.

Now, a high beta stock will outperform when the market is moving up, but it will underperform when the market is going down. 

With a low beta stock, you’ll see the opposite: low beta equities will typically underperform in a bull market, but will outperform in a bearish market.

And this is why managing your portfolio’s beta is so important to managing your directional risk.

When your portfolio’s beta is balanced … It can help ensure that if the market makes a big move in one direction or the other, you won’t suddenly find your trading account blown to smithereens.

Think about it … if you were all long calls in March 2020 … how do you think that would have worked out for you?

That’s an extreme example, but I think you get the point.

I try to always maintain a portfolio where I am long both calls and puts. 

Beta weighting your portfolio against an index can help you estimate your portfolio’s exposure to a major move in the market. Many traders use the S&P 500 (Ticker: SPX) as a benchmark, but you can use other indices such as the Nasdaq 100 (Ticker: NDX), Russell 200 (Ticker; RUT), or even the beta of a specific sector.

When you have a relatively balanced portfolio (notice that doesn’t necessarily mean a 50/50 split between puts and calls, as a truly balanced portfolio will be dependent on the beta of your positions), you can effectively remove your beta bias in either direction.

As we anticipate turbulence in the months ahead, learning to manage your position’s beta will become increasingly important to making sure your portfolio isn't completely at the mercy of the market.

Your Only Option,

Mark Sebastian