The market conditions can massively impact a security, and we know it. There are times when they push the security’s price. Here is where the downside risk enters. It can estimate the potential loss of a security if situations like this happen. It will tell us how lousy an investment can get and how many losses an investor can get. However, some people are skeptical about this estimation because it does not consider some important factors like the profit potential. It is a one-sided test.
Diving deeper into downside risks
Have you heard of the terms “finite” and “infinite” risks? In general, finite means something that has boundaries, while infinite means something that has no end. We also have that in trading and investments. An investment can have finite or infinite downside risks. When an investment has a finite downside risk, it has a zero boundary, and it means that the investor can lose it all, but he will not have any deficits or negative balance. On the other hand, an investment like a short position in a stock accomplished by a short can have infinite or unlimited downside risks. Why? It is because we can never tell when the security’s price will stop rising.
Let us look at another example. Regardless of whether it is a call or a put, a long option may also have a downside risk that is limited on the option’s premium price. On the other hand, a short call option may pose an unlimited downside risk because a stock can rise indefinitely. We also have short puts that only have limited downside risks because it is impossible for the stock or the market to decline more than zero.
People need to know the estimates.
People involved in trading and investments try their best to know how much decline the instrument’s value can go. They want to know, even if it is just an estimate and not an accurate figure. It’s natural to be curious about previous performance or standard deviation calculations because they can help in decision-making. How? If an investment has more risks to offer, does it not make sense to think that it also has more potential profit to offer? An investor will not risk a lot of things in vain. There should be a reason behind accepting all the risks. And most likely, it is because the investment is worth the risk as it can give more potential for positive rewards and benefits.
Let us cite examples.
Downside risk comes with different measures, as we mentioned earlier. Let us learn some of the most common ones:
- Semi-deviation (Downside deviation). It is a standard deviation variation that only measures the deviation if it has terrible volatility. It tells us the massiveness of the deviation in the losses.
- SF Ratio (Roy’s Safety First Criterion). Investors and analysts employ it as they allow portfolio evaluation based on the probability that the returns will decline below a minimum preferred threshold. The optimal portfolio minimizes that probability.
- VaR (Value at risk). If the probability, typical market condition, and the time frame are given, VaR can tell us how much the company and its portfolio can lose.
For the recap
Downside risk gives us an idea of how big the losses a security can incur if the market condition triggers a price decline in the security. It is another term for risks of losses in an investment. An investment may have finite or infinite downside risk. Some examples of downside risks include the semi-deviation, VaR, and SF Ratio.