Every investment in the market will have two fundamental components - risk and return. These are measured by two statistical variables - beta and alpha. Alpha measures the risk of stock positions and the stock volatility relative to a market benchmark.
In detail, beta in trading is a mathematical measure that helps the traders to define the relative risk profile of an investment. Beta was initially originated in the stock trading. In order to understand how well the beta works in forex trading, it is essential to know how the beta coefficient helps investors to choose stocks that are moving against the overall market average.
The beta coefficient measures the relationship between a stock’s price and the volatility of the market.
Beta coefficient β(x) = Slope of stock x / Slope of market average
It can be considered that if the value of the beta coefficient is higher, the impact will be stronger. In detail,
If the beta coefficient is equal to 1, it implies that the security price is in line with the market.
When the beta coefficient is less than 1, it indicates that the return is not likely responding to the market movements.
When the beta coefficient is more than 1, high volatility is being indicated, and the return is more likely responding to the market movements.
For example, assume that the price of a stock increases by 30%, and the overall stock market rises by 10%, then the beta coefficient will be 30/10, which equals 3.
This indicates that the stock price is thrice as volatile as the overall stock market average. Similarly, if a stock that is having a beta of less than 3, assuming that as 2, which means then the stock is twice lesser than the overall stock market average.
Using Beta in Forex
The currencies are valued and traded against one another, and the forex market does not possess inherently upward bias as that of stock markets. Therefore, the usage of beta in the forex is a little complicated compared to that of stock.
The stock market usually moves higher depending on the economic growth or other related factors. But, the forex market fluctuates and therefore the simultaneous purchase of one particular currency can reflect on the sale of the other currency.
So, calculating the beta with the comparison of forex with the forex market average will not sound good. A standard beta trading strategy implies creating a market average of currencies that is set for dollar values. These averages can then be compared by a standard deviation.
The formula to calculate beta in forex is,
β (EURUSD) = σ (EURUSD) / σ (Market Average)
Where β is the beta, and σ is the standard deviation.
This method of beta calculation shows the relation of currencies with each other with reference to volatility. That is, with beta, the traders can trade the currencies that are more volatile than others. The currencies with high beta are considered as highly volatile, and those imply as the most suitable currencies to trade as they possess the highest risk. Conversely, the currencies with low beta are considered least volatile.
If a trader is looking for huge profits in a shorter period of time, choosing the currency that has a high beta would be the right decision. Contrarily, if a trader is averse of the risk or looking for more stable returns, choosing the currency that has a low beta would be better. The same can be applied for any financial instruments.
Beta can benefit investors to measure the stock’s or currency’s volatility concerning the overall market average. However, when it comes to the Forex market, the beta risk measurement or strategy is not broadly used. Investors or traders can calculate the best risk to reward ratio for which they are willing to trade in.
In fact, the beta may not remain consistent over time, and it cannot be concluded that currencies with high beta continue to be more volatile than the average in the future. As this is the nature of trading, and this applies to any trading strategies, it would be better to test any strategy and ensure if it works profitably.