DEFINITION of 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.
BREAKING DOWN Downside
Downside is expressed in terms of an estimation of a security or economy's potential to experience negative movement. A stock analyst, for example, would forecast how far a stock price might fall because of certain events, estimating the downside. Economists can estimate the downside to a country's economy due to current conditions, such as unemployment and GDP growth.
If you buy a stock, your theoretical downside is 100% loss if the stock goes to $0. However, the likelihood of that might be small. That’s where calculating downside risk comes into play. The higher the risk the greater the downside risk.
For most assets the downside is capped, as a price can’t go below $0. Yet, in short-selling, your downside is the reverse of being long a stock. If the price of a stock rises while short, you lose money. In this case, your downside is theoretically infinite, as a stock price can rise to infinitely.
Downside versus 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 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 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’s no way to perfectly estimate the downside unless some sort of downside protection is in place.
Protecting Against Downside
Investors can protect themselves, or their portfolio, against downside by hedging losses. This is known as downside protection. The downside can be capped with the use of options, which can help reduce and limit potential losses. As well, purchasing assets that have a negative correlation to the asset one is looking to hedge can limit the downside. There’s also stop loss orders, which automatically sell a security when it falls at or below a certain price.