How to Measure a Stock’s Temperature

Wouldn’t it be great if before you bought anything, you would know its value in the future? That means, before you slap down a deposit on a new car, you would know its value next week, next month or next year.

Or even better, something that would tell you how much your house would be worth at any point in the future. Based on the national average, you could predict the value of houses in your state and suburb…perhaps even your street.

It sure would help you know where best to invest your money. It would even feel like you are getting an inside run.

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How beta measures can guide your decisions

For stock investors, they already have a tool that can help them see what a price should do. Its name is Beta. Beta tells you how much your stock will move compared to the overall market.

In other words, beta measures the volatility of a stock compared to the index. Investors who don’t like big swings might prefer to invest in stocks with a lower Beta.

Because the market is the basis of the comparison, it has a value of one. Every stock in that index has its own individual Beta — that is how much it moves compared to the index (market).

Any stocks with a Beta above one will have a greater move than the overall market. And any stocks with a Beta below one, move around less than the overall market. The latter are stocks that barely move whenever the market has a big day, whether up or down. Stocks like utilities, for example.

A stock with a Beta of 1.2 is 20% more volatile than the market. And a Beta of 0.8 means that a stock is 20% less volatile than the market.

Reuters calculate the Beta of market heavyweight Commonwealth Bank of Australia [ASX:CBA] at 1.10. And BHP Group Ltd [ASX:BHP], a Beta of around 1.12.

By comparison, energy utilities company AusNet Services Ltd [ASX:AST] has a Beta of just 0.77.

However, there is one important thing to note. Beta is only a guide, a predictor if you like. Nothing is set in stone — it tells you how much a stock will move based on its historical performance.

The Beta for stocks like those mentioned above, BHP, CBA and AST don’t vary too much. In some way, that reflects their sheer size. A big move for a stock like CBA is something like 4–5% — such as we saw this morning — when bank stocks jumped on the open (from a positive reaction to the royal commission report).

Smaller and more speculative stocks will often have a higher Beta. Because of their market cap, they can swing much further if big orders for its stock hit the market.

It is also possible for stocks to have a negative Beta. That is, they move in opposite direction to the market, such as an ETF that short sells the index.

Delta can tell you how much an option price will move

With options, there is also a handy tool that helps you work out what an option price will do. It too uses a Greek word, but in this case its name is Delta.

Delta tells you how much an option price will move in relation to the underlying share. Call options have positive Deltas between zero and one.

A call option with a Delta of 0.5 means that the option price will move 50 cents for every $1 move in the underlying shares.

Again, like Beta, it is not set in stone. However, it is a handy gauge to let you know how much you can expect an option price to move.

Put options have negative Deltas between zero and minus one. That is because put options decrease in value as the share price rallies. And, they increase in value as a share price falls.

As I say, they are a guide. But you can see how both Beta and Delta can give you an insight into what a share or option price will do. In doing so, they can help you measure the temperature of shares and options in your portfolio.

Regards,

Matt Hibbard,
Editor, Options Trader

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Matt Hibbard is Money Morning’s income specialist. With nearly three decades in the markets, Matt has traded just about every asset class there is. The one thing that has stuck with him over this time is a very simple premise. That is, it’s the cash a company generates that ultimately determines its value. Sure, some stocks might fly away to multi-digit gains. But unless these companies can convert the ‘story’ into real money, the market will eventually find them out. And when that happens, the share price quickly falls back to Earth. Matt is also the editor of Options Trader, where he shows subscribers how to use basic options strategies to generate income. This is income they can generate on top of regular dividend payments. Matt doesn’t play the prediction game, where the aim is to be proven ‘right’. Instead, his goal is to generate as much income as he can for his subscribers, irrespective of whether the market is going up or down.


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