What Is Downside Protection?
Downside protection on an investment occurs when techniques are employed to mitigate or prevent a decrease in the value of the investment. Downside protection is a common objective for investors and fund managers to avoid losses, and several instruments or methods can be used to achieve this goal.
The use of stop-loss orders, options contracts, or other hedging devices may be used to provide downside protection to an investment or portfolio.
- Downside protection is meant to provide a safety net if an investment starts to fall in value.
- Downside protection can be carried out in many ways; most common is to use options or other derivatives to limit possible losses over a period of time.
- Protection from losses can also be achieved through diversification or stop-loss orders.
- Protecting an entire portfolio from losses may not make sense depending on how much the protection costs and when the investments are expected to be cashed in.
Understanding Downside Protection
Downside protection comes in many forms. Downside protection often involves the purchase of an option to hedge a long position. Derivative-based forms of downside risk protection are often looked at as paying premiums for "insurance"—a necessary cost for some investment protection.
Other methods of downside protection include using stop-loss orders, trailing stops, shorting closely-related securities, or purchasing assets that are negatively correlated to the asset you are trying to hedge. Diversification is another broad-based strategy that is often touted for reducing risk while maintaining a portfolio's expected return. Loading up on uncorrelated assets to diversify the entire portfolio is an involved process that will impact asset allocation and the risk-reward profile of the portfolio. The costs of downside protection in time and dollars must be weighed against the importance of the investment and when it is expected to be sold.
When stocks rise and fall, gains and losses are on paper. An investor doesn't lose money on a falling stock until the shares are sold at a price that's lower than they paid. Investors may choose to wait out a period of low performance, but fund managers looking for downside protection are usually more pressed for time. Fund managers may sell out of positions in their fund if their screens indicate they should. Exiting weak positions and going to cash can help create downside protection for the fund's net asset value if the market starts to fall.
Example of Downside Protection: Put Options
Sometimes, the best downside protection is waiting out a market correction. For those who don't want to wait, an example of downside protection would be the purchase of a put option for a particular stock, where it is known as a protective put. The put option gives the owner of the option the ability to sell the shares of the underlying stock at a price determined by the put's strike price. If the price of the stock falls, the investor can either sell the stock at the strike price of the put or sell the put since it will have increased in value because it is in the money. Either of these approaches limit loss exposure and provide downside protection.
For example, Bert owns 100 shares of XYZ stock and is concerned about the price falling because he needs to sell it soon. XYZ stock is currently trading at $35/share. Bert can purchase a put on the 100 shares of XYZ stock for $32/share. If the price of XYZ stock falls below $32/share, the put gives Bert the ability to sell the stock to the writer of the put for $32/share. Bert has limited his losses on the XYZ stock and provided downside protection.