Beta weighting is the comparison of volatility between a stock or portfolio and another instrument, such as an index.
Beta measures the correlation of a stock to another stock or index, usually the S&P 500 (broad market). Beta also tells how much (magnitude) that asset will move in relation to the market. A beta of 1 is assigned to a stock which tends to move equivalent to the index on a percentage basis. Stocks which move less than the index have a beta below 1, and stocks which move a higher percentage than the index will have a beta greater than 1.
For example, a stock with a beta of 2.5 will not only tend to advance when the market rises (positive correlation), but it will see an advance typically 2.5x as much (market rises 1%, the stock rises 2.5%).
It’s a common practice among traders to beta weight in order to approximate market exposure. For example, a portfolio of large-cap blue chip stocks would appropriately be beta-weighted against the S&P 500, or SPY. In doing this, the trader can determine how the portfolio value might change given a hypothetical move in the S&P or SPY. This not only allows for the estimation of profits or losses, but also reveals beta weighted delta exposure in order to hedge. By beta weighting, individual positions with excessive exposure can also be identified.
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