What Is Price Risk?
Price risk is the risk of a decline in the value of a security or an investment portfolio excluding a downturn in the market, due to multiple factors. 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).
- Price risk is the risk that the value of a security or investment will decrease.
- Factors that affect price risk include earnings volatility, poor business management, and price changes.
- Diversification is the most common and effective tool to mitigate price risk.
- Financial tools, such as options and short selling, can also be used to hedge price risk.
Understanding Price Risk
Price risk hinges on a number of factors, including earnings volatility, poor management, industry risk, and price changes. A poor business model that isn't sustainable, a misrepresentation of financial statements, inherent risks in the cycle of an industry, or reputation risk due to low confidence in business management are all areas that will affect the value of a security. Small startup companies generally have higher price risk than larger, well-established companies. This is mainly because in a larger company, the management, market capitalization, financial standing, and geographical location of operations are typically stronger and better equipped than smaller companies.
Certain commodity industries, such as the oil, gold, and silver markets, have higher volatility and higher price risk as well. The raw materials of these industries are susceptible to price fluctuations due to a variety of global factors, such as politics and war. Commodities also see a lot of price risk as they trade on the futures market that offers high levels of leverage.
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 an outbreak of foodborne illness. 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.
Futures and Options to Hedge Price Risk
Price risk can be hedged through the purchase of financial derivatives called futures and options. A futures contract obligates a party to complete a transaction at a predetermined price and date. The buyer of a contract must buy and the seller must sell the underlying asset at the set price, regardless of any other factors. An option offers the buyer the opportunity to buy or sell the security, depending on the contract, though they are not required to.
Both producers and consumers can use these instruments to hedge price risk. A producer is concerned with the price moving lower and a consumer is concerned with the price moving higher. An investor, depending on the position they take in an investment, will be concerned with the price moving in the opposite direction of that position, and therefore can use a future or option to hedge the other side of the trade.
Example of an 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 they 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.