What is Downside Protection?
Downside protection on an investment occurs when the investor or fund manager uses techniques to prevent a decrease in the value of the investment. It is a common objective of investors and fund managers to avoid losses and many instruments can be used to achieve this objective. The use of options or other hedging instrument in order to limit or reduce losses in the case of a decline in the value of stock is very common.
- Downside protection is meant to provide a safety net if an investment starts to fall in value.
- Downside protection can be done in many ways, but the most common is to use options or other derivatives to limit possible losses over a period of time.
- 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. Other methods of downside protection include using stop losses or purchasing assets that are negatively correlated to the asset you are trying to hedge. The more common, derivative-based forms of downside risk are often looked at as paying for insurance - a necessary cost for some investment protection. Loading up on uncorrelated assets to diversify the entire portfolio is a much more 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.
Of course, it is always important to remember that when stocks go up and down, the increases and decreases in price only represent gains and losses on paper. An investor has not lost anything until they sell a share and accept the low price in exchange for giving up the share. 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 several positions in their fund if their screens indicate they should do so. 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
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. The put option gives the owner of the option the ability to sell the share of underlying stock at a price determined by the put. If the price of the stock falls, the investor can either sell the stock at the price listed on 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 very concerned about the price of XYZ stock 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.