Understanding Alpha and Beta in Trading

When measuring the performance of any asset, two letters, “Alpha” and “Beta” consistently come up as key metrics. They are more than just Greek symbols, they speak to the relative performance and volatility against benchmark indexes. Usually alpha and beta are weighted against the S&P500.

Alpha: Performance Against Benchmark

Alpha, often referred to as the holy grail of investing, is the excess return generated by an investment in relation to its benchmark or the broader market. It is the measure of a strategy’s or stock’s ability to outperform or underperform the market. A positive alpha signifies outperformance, indicating that the asset or portfolio has delivered returns beyond what would be expected given its level of risk. Negative alpha, implying underperformance.

By subtracting the expected return (based on the asset’s beta and the risk-free rate) from the actual return, alpha provides a quantitative measure of an asset’s ability to deliver returns regardless of market conditions.

Let’s illustrate this with an example: if an investment generates a 12% return while the benchmark yields 10%, the alpha would be +2% given risk parameters are constant. This implies that the investment manager’s selection has added 2% in excess returns.

A more practical example is Warren Buffett’s Berkshire Hathaway’s 19.8% annual return from 1965 to 2022, compared with 9.9% for the S&P 500 during the same time. You could say that Berkshire had positive alpha. Note though, without knowing the exact beta and risk free rate over the timeframe, it would be impossible to calculate exactly how much alpha was there.

Beta: Volatility Against Benchmark

Beta should be more heavily discussed as it measures the sensitivity of an asset’s returns concerning broader market movements. A beta of 1 suggests the asset moves in tandem with the market, while a beta greater than 1 indicates higher volatility, and a beta less than 1 implies lower volatility. Growth stocks think, TSLA, will generally have a beta higher than 1. A government backed treasury will likely have a beta well below 1, even approaching 0.

As traders, we typically aim for assets with high beta that will move large ranges on an intraday basis. If trading options, generally looking for something that will travel 1 delta or more on a given day is preferred. For newer traders, once you learn the basics of technical analysis, starting with low beta names and small position sizes will give you the feel for trading without being exposed to high volatility.

Low beta assets can be seen as a defensive play during volatile conditions, in an attempt to reduce the large swings in a portfolio. Conversely, higher beta assets can be used during risk-on (LINK LINK LINK) periods, presenting opportunities for amplified gains (and losses).

Consider a stock with a beta of 1.2; when the market rises by 1%, this stock tends to rise by 1.2%. Conversely, if the market falls, this stock is likely to fall more than the market average.

Conclusion

While alpha and beta might seem like totally different metrics, they actually move in parallels. Often, high beta is the price to pay for higher alpha. If a manager can build a strategy to provide high alpha and low beta we would say they have a high Sharpe ratio. It is imperative to see returns over a large period of time otherwise we don’t account for the law of large numbers. Luck of course can play a valid role in market returns.