The beta coefficient of a stock is a measure of the stock's volatility relative to the broad market. Volatility is a measure of the price change that occurs in either an index (S&P 500) or a specific stock as a response to either positive or negative news. For example, poor employment reports or negative inflation numbers tend to depress the stock market; a stock that is very volatile will drop in price more than a stock that is less volatile. The opposite scenario will occur if there is positive news in the market, the more volatile stocks will rise faster than the less volatile stocks.

Clearly, beta is just one factor that contributes to the price of a stock. If two stocks or companies are in the same industry-such as Home Depot and Lowe's-and have equivalent business models and financial profiles, everything being equal, the more volatile stock will rise faster in a bullish market and fall faster in a bearish market.

The market is measured by an index (S&P 500) and is assigned a beta of 1 and stocks are evaluated relative to the market. As a result, stocks are either correlated with the markets and have a positive value, or they are negatively correlated with the market and have a negative value. Beta is calculated based on historical stock prices and index prices. An example calculation is a linear regression of the daily change in closing prices of the S&P 500 of a given period versus the change in closing prices of a given stock Z over the same period. Remember the equation Y=MX + C? X is the daily percent changes in the price of the S& P 500 and Y is the daily percent change in the prices of stock Z. M in the regression analysis is the slope. In this case, the slope M is the stocks beta.

If a stock has a beta of 2 in a bull market and the S&P 500 experiences a 5% increase, the stock should experience a 10% increase. Likewise, if the S&P 500 experiences a decline from 10% to 5%, the stock with a beta of 2 will drop by 10%.

Beta is a good measure of the volatility of a stock, and is often used by investors in bullish markets to increase their returns. Beta can also be used in a bearish market to increase returns by selling short in advance of a significant market decline or by purchasing puts. A stock's beta is used extensively by sophisticated investors to determine the stock's fair value and also in determining the fair value of the stock's options.

Beta is synonymous with risk. A stock with a beta of 1, indicates that the stock's price will move with the market. A beta of less than 1 indicates that the stock is less volatile than the market and a beta of greater than 1 means the stock is more volatile than the market.

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