What Is Downside?
Downside is the negative movement in the price of a security, sector or market. Downside can also refer to economic conditions, describing potential periods when an economy has either stopped growing or is shrinking.
- Downside describes the negative movement of an economy, or the price of a security, sector, or market.
- Your theoretical downside is 100% if the stock you bought falls to $0. However, if you short the company, your downside is not capped and is theoretically infinite.
- For the most part, the higher the downside potential the greater the upside potential.
- There are numerous ways that investors can protect themselves against downside.
How Downside Works
Downside is expressed in terms of an estimation of a security or economy's potential to experience negative movement. A stock analyst, for example, may forecast how far a stock price might fall because of certain events. Meanwhile, economists can predict the downside to a country's economy by taking into consideration factors such as the unemployment rate, inflation, and gross domestic product (GDP) growth.
Examples of Downside
That’s where calculating downside risk comes into play. In general, the higher the risk the greater the downside risk.
For most assets the downside is capped, as a price cannot go below $0. Exceptions include short selling, a trading strategy that enables investors to speculate on the decline of a stock or other securities price. If the price of an asset you shorted rises, you lose money. Moreover, your downside is theoretically infinite, as the price can keep on climbing.
Downside vs. Downside Risk
A movement to the downside is often expressed in terms of risk, such as the downside risk to a particular country's economy, or the downside risk to a company’s stock because of changing consumer trends. Downside is the potential negative movement, while downside risk looks to quantify that potential move.
For the most part, the higher the downside potential the greater the upside potential. This goes back to the idea of the higher the risk, the higher the reward. Upside is the positive move in an asset price.
Downside risk can be evaluated with fundamental and technical factors, estimating the amount a security or asset price might fall in the worst-case scenario. This can be done using probabilities or standard deviation models, although there is no way to perfectly estimate the downside unless some sort of downside protection is in place.
Downside protection provides a safety net if an investment starts to fall in value. This can be achieved in several ways, including:
- Put option: A contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a certain time frame. 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.
- Stop loss: An order placed with a broker to automatically sell a security when it falls at or below a certain price.
- Purchase different assets: A diversified portfolio made up of assets that are negatively correlated can ease downside risk. When one rises, the other tends to fall, cushioning losses but also limiting potential gains.
Alternatively, investors might opt to wait out a market correction, hopeful that the stock will bounce back in the future.