Upside/Downside Explained

Friday, July 16, 2021 | Chris Markoch
Upside/Downside Explanation

There’s a reason why your level of risk tolerance is one of the most important that an investor can understand. Every investment decision you make carries some level of risk. However, without any risk there can be no reward.

One way for investors with a high-risk tolerance to profit from stock investing is to look at stocks that have a high upside or downside. Stocks with a high upside are viewed as stocks that should be priced higher than they are at that moment. Conversely, stocks with a high downside (or downside risk) are viewed as stocks that should be priced lower than their current price.

The degree to which a stock has upside or downside potential is determined using fundamental and/or technical analysis. Some investors and fund managers have preferred signals they look for when attempting to forecast future price movement.

However, as the meme stock movement of 2021 has shown investors, investors (and therefore stock prices) do not always behave in predictable ways. That’s why investors with a low tolerance for risk should think very carefully before engaging in stocks with a high upside or downside. In many cases,  slow and steady wins the race.

Introduction

Upside and downside are two sides of a coin that investors must evaluate. To say a stock has upside is to say it has the potential to increase in value. By contrast, when a stock has downside it has the potential to decrease in value. Upside and downside is either expressed in dollars (i.e. a price target) or as a percentage. 

Analysts use either fundamental or technical analysis to arrive at conclusions about a stock’s future price movement. When a stock has upside, analysts will typically upgrade the stock. Conversely when a stock has downside, an analyst may downgrade the stock.

In this article we’ll look at what each term means individually. We’ll also look at strategies that can help you understand how to forecast the upside or downside risk in a stock.

What Does Upside Mean?

Upside refers to the potential increase in value of a stock. Stocks with a higher upside are perceived to have more value than is currently reflected in its stock price. The potential upside movement is highly correlated with the risk associated with a particular stock. That is, stocks that have the greatest upside will generally have higher downside risk. This makes them attractive to investors with a high risk tolerance. However, more risk-averse investors will likely look for safer options.

If an investor doesn't want to buy a stock with high upside directly, they may choose to buy a call option. This gives an investor the right, but not the obligation to buy a stock at a predetermined price at a predetermined future rate. If the price on the stock rises, the investor can buy the stock at the price listed on the call option and pocket the profit. If the stock price falls, the owner can simply allow the call option to expire.

Understanding the Upside/Downside Ratio

Many investors hold the majority of their portfolios in mutual funds or exchange-traded funds (ETFs). In a passively managed fund, the goal of many of these funds is to closely approximate the performance of a specific index (e.g. the S&P 500 index).

However, if a fund is actively managed, the goal is to produce a return that is greater than the index being tracked. To help identify stocks that will help accomplish this objective, a portfolio manager may use a metric known as the upside/downside capture ratio to track a particular stock against a benchmark index.

This ratio provides a snapshot of how a particular stock performs in relation to its benchmark index. If a stock has an upside/downside ratio of 100 (which rarely happens) it means that the investment performs identically to its benchmark.

Simply put, that means if the S&P 500 was up 18% for the year, the stock being analyzed would also be up 18% for the year. Likewise, if an index was down 18% for the year, the stock would be down 18%.

With that in mind, you can see why investment managers will look for stocks that have the potential to rise above the index it is tracking.

How Does Upside Play Into Short Selling?

Short selling occurs when an investor is selling a stock that they do not actually own. When a stock is sold short, the individual doing the selling must deliver borrowed securities to the buyer by the settlement date. If a stock rises, the seller gets squeezed and will have to buy back shares at a higher price than they borrowed them to cover their position.

For this reason, short-sellers look to buy stocks that look to have minimal upside potential because that increases the likelihood that the stock price will decrease.

What Does Downside Mean?

Logically downside refers to the potential decrease in the value of a stock. Downside is quantified in terms of downside risk. In terms of stocks there is usually a high correlation between upside risk and downside risk. That is stocks that have a high upside potential generally also carry a high downside risk. Penny stocks frequently display this dynamic. It doesn’t take much movement to get these stocks to move significantly higher. However, as these stocks move higher, it doesn’t take much to get the stock to correct to the downside.

How to Manage Downside Risk?

Passive investors who have a long time horizon and who feel optimistic about the mid- to long-term fortunes of the stock may simply choose to wait out the correction in the stock price. Active traders who are looking to maximize their portfolio’s return at all times have several “hedging” tactics to provide a safety net if an investment starts to fall in value. Some of the most common include:

Buying put options: Put options are contracts that give the owner the right, but not the obligation, to sell a specified amount of an underlying security. Put options are purchased at a specific price and for a specified time frame. If the price on the stock falls, the investor can sell the stock at the price listed on the put option. If the stock price rises, the owner can simply allow the put to expire.

Use stop losses: This is an order that automatically sells a security when it falls at or below a certain price.

Rebalance their portfolio: A diversified portfolio includes assets that are negatively correlated. This can ease downside risk because when one asset class is falling, others will tend to rise. This is a more conservative approach because while it can minimize losses it will also restrict gains.

How to Forecast Upside/Downside Potential

Analysts and investors use either fundamental or technical analysis to project the upside potential of a particular stock. In fundamental analysis, a stock is viewed by factors like projected sales and earnings. Investors will also look at things like how much debt a company has and how much of their revenue will have to be used to service the debt.

Generally speaking a company with consistently increasing earnings (i.e. profits) will have a higher upside than one where earnings are flat or declining. However, this isn’t always the case. If there is an obvious reason for the drop in earnings, investors can take that into account.

For example, during the Covid-19 pandemic in 2020, many quality stocks were oversold early on. Although earnings went down, many analysts saw this as a buying opportunity and, in many cases, were rewarded as these stocks quickly recovered.

Conversely, a company that displays poor fundamentals over a length of time is considered to have a high downside risk. The degree of that risk will depend on many factors including the sector that it’s in. For example, there are many cyclical stocks, such as entertainment stocks, that will tend to perform well in an economic upcycle, but frequently turn negative in an economic downturn.

Investors that favor technical analysis view price and/or volume movement as an indicator of trends. So when a stock that has been trading within a defined range breaks higher, that is seen as a technical indicator that the stock has a value above that price.

The opposite is true for looking at downside. If a stock that has been trading in a narrow range breaks to the downside, it is usually an indicator that the stock has further to fall.

The last word on upside/downside

Risk versus reward is a proposition as old as investing. However, many novice investors confuse upside/downside risk with the idea of buying low and selling high. That can be true. However, in many cases, it’s more accurate to say investors want to buy high and sell even higher. There are many examples of stocks that have seen their prices go up significantly, yet still have more room to grow.

On the contrary, there are many examples of investors who bought a stock that was on the downside thinking that it was bound to go up. However, that isn’t always the case. Sometimes even good stocks get caught in a wave of negative headlines and/or negative investment. When this happens, the stock price can act like a falling knife. And investors who try to invest on the downside frequently lose money.


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