What is Downside Protection?

//What is Downside Protection?
What is Downside Protection? 2017-10-03T07:15:54+00:00

Definition: Downside protection is a strategy implemented in options to hedge the risk of volatility and lower or eliminate the losses of a portfolio in case the price of the underlying asset decreases.

What Does Downside Protection Mean?

What is the definition of downside protection? These strategies help investors protect their portfolio holdings against significant losses. Given the volatility of the financial markets as a result of the global financial strategies it is important to maintain the option of protecting one’s portfolio while allowing maximum participation in the upside potential.

To that end, investors can buy an option to hedge their long positions, use stop limit orders or buy underlying assets that can hedge the risk of the underlying asset they already own.

Let’s look at an example.

Example

On August 10, Annabel owns 100 shares of a restaurant company that trade at $44. She already owns the asset, and she wants to protect her position in case the price of the stock drops to $40. What can Annabel do to hedge against the downside risk?

Annabel buys a put option at a strike price of $46, and she pays a premium of $200 ($2 per share as each option contract covers 100 shares).

If the stock price rises to $55, Annabel will realize a gain of ($55 – $46) x 100 shares = $900. Therefore, her net gain is $900 minus the premium of $200 = $700.

If the stock price drops at $38, Annabel will realize a loss of ($46 – $38) x 100 shares = $800. If Lily hadn’t purchased a downside protection, her net loss would be $800 minus the premium of $200 = $600. However, because she bought the down side protection, she loses only the premium of $200.

Therefore, by purchasing a down side protection, Annabel limits her losses to the premium paid for the underlying asset if the stock price drops below the strike price. At the same time, she takes advantage of the upside potential if the stock price rises above the strike price.

Summary Definition

Define Downside Protection: Downside protection is a tactic used by investors to mitigate risk and protect their funds by hedging their investments in case they decrease in value.