As an investor, it is likely you have already come across high-beta stocks. These stocks can significantly overperform in bull markets and underperform in bear scenarios. While we would not advise relying solely on beta to determine trades, you generally cannot afford to ignore this volatility factor. In this article, we will discuss how you can use beta and debit options spreads together to trade high-volatility stocks for potential profit.
Key takeaways
- High-beta stocks tend to overperform the stock market in a bull phase, while they will underperform it in a bear scenario.
- If you have an expectation on how the stock market will fare over the next few weeks, you can design a beta-based debit options spread strategy to profit from the underlying performance.
- Our free backtest lets you check how a high-beta stock behaves in a bull or bear market phase in order to give you a statistical trading edge.
What Is Beta and How Does It Work?
The easiest and non-mathematical definition we could give for beta is that it measures how much a stock’s price moves compared to the overall market. A beta of 1 means the stock moves with the market, while a beta higher than 1 signifies more volatility. Understanding beta is crucial for trading high-volatility stocks effectively.
How Beta Works
When it comes to beta, you can pretty much divide the market between high and low beta stocks. High-beta stocks tend to have more significant price swings compared to the market. During a bull market, high-beta stocks usually outperform the market. Conversely, they underperform during bear markets.
Instead, low-beta stocks are less volatile and do not fluctuate as much as the market. They provide stability but offer lower returns in bullish phases.
Debit Options Spreads
Debit options spreads are a strategy where you buy one option and sell another, both within the same expiration period. This approach can capitalize on high-volatility stocks with reduced cost. For example:
- Bullish Spread: If you expect a high-beta stock to rise more than the market, you can buy a call option at a lower strike price and sell a call option at a higher strike price.
- Bearish Spread: Conversely, if you expect the stock to decline more than the market, you can buy a put option at a higher strike price and sell a put option at a lower strike price.
Note that both strategies above come with a capped risk and lower cost compared to buying naked options, which is why we will propose combining a beta study with this spread strategy. Beta is not as predictable as you may think, and keeping a controlled risk is certainly a smart idea. Selling a naked put on a high-beta stock may end up giving you high losses during a market downturn, which is why a debit spread is the way to go.
Practical Application of the Beta Value Analysis
It’s essential to use beta wisely. Don’t pick a trade solely because the stock has a high beta. Consider the direction you expect the market to move. For instance, if you believe TSLA will decline along with the Nasdaq, you should anticipate TSLA to fall more sharply than the index. This insight helps you choose appropriate strike prices for your options, making your strategy more effective.
Our Idea: Backtesting Beta to Trade High-Volatility Stocks with Debit Option Spreads
We are options traders ourselves, and this is what we had in mind when we thought to test beta before trading.
Step 1: Predefined Scans for Every Investor
Start by examining our predefined scans to identify trade opportunities on high-beta stocks. These scans help you quickly locate stocks that exhibit higher volatility compared to the market. Specifically, we have set up both a bullish and bearish scan to look for high-beta stocks.
Step 2: Market Research
In this phase, you should take care of the following aspects:
- Preliminary Research: Once you have potential high-beta stocks, conduct thorough research to understand whether the market is more likely to move up or down in the coming weeks. This involves analyzing economic indicators, earnings reports, and market sentiment.
- Bullish Indicators: Look for signs that suggest a market uptrend, such as strong job reports, positive earnings, or political stability.
- Bearish Indicators: Watch out for bearish signals like economic downturns, poor earnings, or geopolitical tensions.
Note that, if your research does not give you a clear indication of market direction, you can always choose to sit out and wait for more clarity.
Step 3: Risk Assessment
Based on your market research, decide if you can tolerate the risk associated with the trade. Once again, we chose to base our reasoning on a capped-loss option strategy because we know how hard trading a high-beta stock can be.
As a side note, keep an eye on the overall beta of your portfolio. If you already hold a high concentration of high-beta stocks, it may be prudent to avoid further exposure. For instance, a stock such as NVDA may make you very happy during a calm market phase, but it may really hurt you during a stormy one.
Step 4: Place and Monitor the Trade
Execute the trade based on your strategy. Ensure that your chosen strike prices reflect your market expectations and risk tolerance. Keep an eye on the market and adjust your strategy as needed. Monitor stock performance and market conditions regularly.
Benefits of Using Beta in Options Trading
In terms of benefits when using beta to trade, consider the following aspects:
- Timing the Market: Utilizing beta helps you time the market more effectively. High-beta stocks tend to outperform in bull markets and underperform in bear markets, giving you an edge in both scenarios.
- Informed Decisions: By understanding a stock’s beta, you make more informed decisions about when to enter or exit trades, enhancing your overall trading strategy.
- Consider the Historical Beta: The beta of a stock tends to fluctuate around a long-term average value. We mentioned TSLA and NVDA above, but the truth is that even those stocks have had periods where their beta was much lower than average. Consider the historical beta of a stock before making any trading decisions.
Tips for Setting Up Trades Based on Beta Readings
We can share a few intuitive tips for trading the market based on beta.
First of all, choose strike prices that align with your market outlook. For example, for a bullish trade, select strikes that reflect moderate to significant upward movement (in other words, try to keep the profit probability of your trade on your side, with realistic expectations).
Also, be prepared to adjust your spreads if the market shows unexpected volatility. Flexibility can help you manage risks better.
As a general rule, always review historical beta data during backtesting to understand how the stock has behaved in past market cycles. This can provide valuable insights into future performance.
Using Our Backtest File for Options Investment
Let us guide you through using our backtest file to trade high-beta stocks with debit options spreads.
Step-by-Step Guide
Here is a quick step-by-step guide to start using our backtest file for high beta stocks.
Step 1: Find a High-Beta Stock
- Scanner: First, go to our options screener and locate a high-beta stock. For this example, we’ll use TSLA, which is currently trading at $232.10.
- Research: Assume you’ve done your research and, despite TSLA’s recent poor earnings report, you believe the company will outperform the market. With a bullish market expectation, you’ll look into bull call spreads.
Trade Setup: With TSLA at $232.10, you could buy a $210 call and sell a $265 call expiring in 52 days. This is what your P&L profile would look like:
And here is what you should take from the chart above:
- Breakeven Point: $234.36
- Maximum Loss: $2,436.25
- Maximum Profit: $3,063.75
Note that, when selecting a trade, our scanner will also tell you that your maximum return on margin is equal to 125.76% (or 874.48% annualized).
Step 2: Use the Backtest File
- Enter Ticker: Open our backtest file and input the ticker symbol (TSLA).
- Set Parameters: Choose the year to start your statistical analysis (e.g., 2010) and input the number of days until expiration (in this case, 52).
Here is what your Google Colab file should look like, at this point:
Click on the “Runtime” menu and select “Run all” to initiate the backtest. Once you’ve initiated the backtest, our system will analyze historical data to simulate how TSLA’s beta has impacted its price movements over the chosen period. It will consider various market conditions, allowing you to see potential outcomes of your trade based on past performance.
Next Steps
The next section of our guide will explain how to interpret the output from the backtest on TSLA. Understanding these results will help you make informed decisions about whether to proceed with the trade and how to manage it effectively.
Using our backtest file allows you to:
- Validate Your Strategy: Ensure that your debit options spread strategy aligns with historical performance.
- Manage Risk: Determine the likelihood of different outcomes, helping you assess risk more accurately.
- Optimize Returns: Fine-tune your strike prices and expiration dates to maximize potential returns based on beta readings.
Trading Stocks with Debit Options Spreads (while Keeping an Eye on Beta)
At this point, you are ready to take a look at the output of the beta analysis on TSLA that we set up in the previous section.
Analyzing Beta for TSLA
The first aspect you should focus on is the beta value, which is currently equal to 2.10, as you can see below:
It’s essential to note that TSLA’s beta has varied significantly over time, ranging between 0.81 and 2.32. This indicates that we are currently in an above-average period for the stock’s beta value. The long-term mean beta for TSLA is 1.46. In this sense, a graphical representation of how beta changes over time can be very interesting, as you can see below:
Note from the chart above how cyclical TSLA’s beta is. While we won’t delve into trading beta’s mean-reverting nature in this article, remember that beta fluctuates over time.
Implications of High Beta
Given TSLA’s high beta, the idea that a bullish market phase could yield substantial returns for TSLA bulls is logical. If we examine the average performance during the first 52 days of a Wall Street bull phase (measured using a positive Aroon indicator), TSLA tends to outperform the S&P 500 for the first 40 days on average. Refer to the chart below, where you have the average daily cumulated price of TSLA in blue (with a 75% confidence interval area) vs. the average SP500 cumulated price in black:
Here are a couple of things you should know:
- Aroon Indicator: As a premise, consider that the Aroon indicator measures the strength of a trend and the likelihood of its continuation. A positive Aroon value suggests an uptrend. This is the filter we used to determine whether the S&P 500 was in a bullish or bearish phase.
- Average Performance: During a bull phase, TSLA’s performance often exceeds that of the S&P 500, but the confidence interval is broad. This variability means you should not solely base a trade on this analysis; instead, thoroughly study TSLA’s financials.
Consider Downside Risk
It’s crucial to consider what happens if you’re wrong about the market direction. If the market suddenly enters a bear phase, TSLA is likely to perform worse than the S&P 500, as evidenced by the bearish case chart (notice that both the average performance and the confidence are negative compared with average market behavior).
When trading stocks with debit options spreads while keeping an eye on beta, remember these key points:
- Beta Fluctuates: Beta is not stable over time; it moves in cycles.
- Supplementary Analysis: Beta is merely a statistical measurement. Even if Wall Street enters a bull phase, specific adverse news about TSLA could prevent it from outperforming the market.
A Consideration on Beta, its Added Analytical Value, and its Limitations
Last but not least, it is worth to mention that beta is but one analytical tool. While useful, it should not be the only factor you consider when making investment decisions.
Beta can help traders and investors make more informed decisions by providing insights into how a stock may perform during different market conditions. It serves as an additional tool for assessing risk and optimizing returns.
However, it’s crucial to note that beta does have its limitations. For instance:
- Lack of Context: Beta alone cannot provide a full picture of a stock’s historical performance without considering other factors such as company financials, news events, and overall market trends.
- Historical Data Only: Beta relies on past performance and does not take into account future events that may impact a stock’s performance.
- Volatile Nature: As mentioned previously, beta is not stable and can fluctuate significantly over time, making it challenging to rely on as a sole indicator for investment decisions.
Therefore, while keeping an eye on beta can be beneficial in your trading strategy, it should be used alongside other analytical tools and considerations.
