What is 'Price Risk'
Price risk is the risk of a decline in the value of a security or a portfolio that can be minimized through diversification, unlike market risk. It is lower in stocks with less volatility such as blue-chip stocks. Investors can use a number of tools and techniques to hedge price risk, ranging from relatively conservative decisions such as buying put options to more aggressive strategies including short selling and inverse ETFs.
BREAKING DOWN 'Price Risk'Price risk hinges on numerous factors. Large well-established businesses have lower price risk than small startup entities. Certain commodity industries including the oil, gold and silver markets have higher volatility and higher price risk. Management, market capitalization, financial standing, including cash flow, and geographical location of operations are all factors that contribute to changes in an entity’s stock price.
Unlike other types of risk, price risk can be reduced. The most common mitigation technique is diversification. For example, say an investor owns stock in two competing restaurant chains. After a foodborne illness scare at one, the price of the company’s stock plummets. However, this means increased business for the competing restaurant. The decline in market price of one stock is compensated by the increase in stock price of another. Appropriate diversification entails the ownership of stocks of companies in different geographical locations in different industries.
Price risk can be hedged through the purchase of a financial derivative called a put option. A put option gives the holder the right, but not the obligation, to sell a commodity or stock for a specific price in the future regardless of the going market rate. For example, a put option may be purchased to sell a specific security for $50 in six months. After half a year, if price risk is realized and the stock price is $30, the put option may be used to sell the security at the higher price and mitigate price risk.
Price risk may be capitalized through the utilization of short selling. Short selling involves the sale of stock in which the seller does not own the stock. The seller, anticipating a reduction in the stock’s price due to price risk, plans to borrow, sell, buy and return stock. For example, upon the belief of a specific stock’s imminent downturn, an investor borrows 100 shares and agrees to sell them for $50 per share. The investor has $5,000 and 30 days to return the borrowed stock he sold. After 30 days, if the price of the stock dipped to $30 per share, the investor is able to purchase 100 shares for $30, return the shares from where they were borrowed and keep the $2,000 profit due to the impact of price risk.