What is Price Risk
Price risk is the risk of a decline in the value of a security or an investment portfolio. It is lower in stocks with less volatility, such as blue-chip stocks. Investors can employ a number of tools and techniques to hedge price risk, ranging from relatively conservative decisions (e.g., buying put options) to more aggressive strategies (e.g., short selling and inverse ETFs).
BREAKING DOWN Price Risk
Price risk hinges on a number of factors. For example, large, well-established businesses have lower price risk than small startup companies. Certain commodity industries, such as the oil, gold, and silver markets, have higher volatility and higher price risk. Management, market capitalization, financial standing, and geographical location of operations are all factors that contribute to changes in an entity’s stock price. Common factors contributing to price risk include earnings volatility, poor management, and price changes.
Diversification to Minimize Price Risk
Unlike other types of risk, price risk can be reduced. The most common mitigation technique is diversification. For example, an investor owns stock in two competing restaurant chains. The price of one chain's stock plummets because of a foodborne illness outbreak. As a result, the competitor realizes a surge in business and its stock price. The decline in the market price of one stock is compensated by the increase in the stock price of the other. To further lessen risk, an investor could purchase stocks of various companies within different industries or in different geographical locations.
Put Options to Hedge Price Risk
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 current market rate. For example, a put option may be purchased to sell a specific security for $50 in six months. After six months, if price risk is realized and the stock price is $30, the put option may be exercised (selling the security at the higher price), thereby mitigating price risk.
Short Selling to Hedge 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 dropped 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.