Investors often use limit orders to buy into stocks, but at what price do you set the limit order? This is a challenge for any investor. To help answer this question, a simple observation of the stock’s beta can be used to determine an entry price when buying a stock.
Beta is a measure of a stock’s volatility compared to the overall market (typically the S&P 500), yet investors do not often have a practical application of beta beyond observing whether the stock has been more or less volatile than the market historically. Beta can be helpful in a number of additional ways. Today I’d like to highlight a simple way beta can help guide you in determining an entry point when purchasing a stock.
Though I don’t consider myself someone who can time the overall market with superior accuracy, I do use limit orders when purchasing stocks. I understand that market volatility is always present and typically I can take advantage of a small swing in prices to buy a stock a little below the quoted priced I observe when I first decide I want X stock in my portfolio.
When considering how drastic the buy price my limit order should be set at compared to the current stock price, the stock’s beta can be used as a general reading on how much price fluctuation should be expected compared to the overall market. A beta below 1 and you have a stock with less volatility, above 1 and you have a stock with more volatility.
Once you’ve decided to purchase a stock and are attempting to determine an entry price to set, look at the beta. Is the figure below or above one? For this example we’ll say it’s 1.5. This means the stock historically has 50% more volatility than the market (S&P 500). In other words, if the market rises by 2%, you should expect a 3% rise in the stock’s value (2% * 1.5 = 3%).
If we have a general understanding of how a stock reacts to market movements, then we can determine a reasonable entry price based on our market forecast. Holding that the market will dip by 5% sometime within the next month means that I should epxect approxamently a 7.5% dip in my example stock’s price. If the stock is selling for $20 at the time of consideration, then I should set my buy limit order to execute somewhere around $18.50 ($20 – ($20*7.5%) = $18.50).
The difficulty with using this predictive framework is that you still are dependent on being able to read the market. Wanting to enter into a position within the next week means being able to accurately predict the market’s movement in the next week.
I am of the opinion that when you are less anxious to enter into a position, this strategy is more effective. Every few quarters you are almost guaranteed that a period of market weakness will exist and some decent amount of selling will occur. This will either be a temporary down-turn or the start of a larger trend. In either case, it’s a window where your limit order will have a greater probability to execute.
Lastly, if you’re basing an investment decision on a specific positive event that you anticipate happening soon or has just occurred, I do not think it is wise to bet on a market pull-back. If you have clearly identified a catalyst for the stock’s growth in the near-term, then you should act on the information.