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Finance Professor: Five Hedging Techniques You Must Know

Scott Rothbort

Hedging is a process by which risk is reduced; however, I'll emphasize that unless you liquidate a position, all risk cannot be eliminated. Hedging can reduce most risk, but as you will see, sometimes you wind up trading one risk for another.

Also, recognize that hedging is typically a short-term strategy to protect long-term positions. It may also be utilized to complete an arbitrage transaction. However, you never want to apply a long-term hedging strategy to a short-term position, as that would be costly and add more risk in the long run.

Here are five essential hedging techniques that you'll learn about in this installment of "The Finance Professor":

• Pairing
• Short against the box
• Exchange-traded funds (ETFs)
• Futures
• Options

1. Pairing

Pairing seeks to offset a position with a similar but not identical security . For example, let's say you are seeking to hedge a stock position, XYZ Corp. The first step is to identify many characteristics of XYZ Corp. that are relevant to its risk profile. These include (but are not limited to):

• Industry/sector categorization ("Industries vs. Sectors: What's the Difference?")
• Market capitalization
• Beta
• Dividend yield
• Historic volatility
("Understanding the Four Measures of Volatility")
• P/E Ratio
• Price/Book Ratio

The next step is to match up target stocks with similar characteristics. Once you ascertain which stock (or group of stocks) best replicate XYZ Corp.'s risk metrics, you can then perform a correlation of the historic prices of XYZ and the target hedges. If there is a high correlation between XYZ and the potential hedge, we have found the right match.

The final step is to short-sell the hedge and thereby pair up XYZ with the hedge. While the match between XYZ and the hedge is not identical, it might provide some short-term risk protection. However, beware that you are adding additional risks, such as the inability to maintain a stock borrow on the hedge or the possibility that the hedge gets acquired.

Here is a real life example. In the early 1990s I was in charge of risk management at County NatWest Securities (CNWS Quote). CNWS was trying to build a proprietary trading and derivative business on its strong foundation of market-making. One day the market makers at CNWS were stuck with a big position in Abbey National (a bank similar to a U.S. savings and loan) which they could not trade out of in larger pieces. This was no secret. I told the market makers to accumulate a short position in its nearest rival or rivals and then work out of the paired position in a piecemeal fashion.

2. Short Against the Box

Selling "short against the box" (SATB) is a unique hedging technique whereby a stock is hedged by short-selling the same exact stock ("What Do I Need to Know About Shorting Stocks?"). This was once a very popular strategy employed by many high-net-worth individuals and hedge funds to avoid capital gains taxes on low-cost-basis holdings.

However, after the abuse of the SATB transaction by the Lauder family when taking Estee Lauder (EL Quote) public (see IPO ) nearly a decade ago ("Why a Blackstone IPO Makes Sense") , Congress placed many restrictions on the use of SATB by eliminating many of its long-term tax benefits. In essence, SATB is now a short-term hedging strategy rather than a long-term hedging and tax-avoidance tactic.

3. Futures

While futures are not available to most individual investors ("Getting Started With Futures"), I would like to draw your attention to its potential use as a hedging technique.

In my lesson discussing managing risk, I included an example of a portfolio of stocks. The total beta adjusted risk relative to the S&P 500 (SPX Quote) (SPY Quote) for that portfolio was $2,619,000. Each SPX futures contract is for 250 times that index.

Let's say the SPX is selling at $1,525. At that price, the market value of each SPX future would be 250 x $1,525 = $381,250. Thus, each SPX future would provide $381,250 of equivalent SPX exposure. With $2,619,000 of portfolio risk, you would have to sell 6.8 contracts ($2,619,000 / $381,250) to fully hedge the position. Since we have to sell whole contracts, our choices would be to sell seven SPX contracts, which would slightly over-hedge the position, or less than seven contracts and slightly under-hedge the portfolio.

Once again, I must admonish that while you may hedge out some risk, since this sample portfolio is made up of only four stocks and the SPX is an index of 500 stocks, then you have an imperfect hedge. The result may be failure of the portfolio to track the hedge, resulting in risk expansion not risk reduction.

4. Exchange-Traded Funds

Exchange-traded funds (ETFs ) open up a whole range of hedging possibilities. Let's look at three alternatives:

• The Spyders: Recalling that the sample portfolio had risk of $2,619,000 vs. the S&P 500 Index. The S&P 500 ETF, commonly called the "Spyders" (SPY Quote), is a trust that replicates the S&P 500. The Spyders are now selling for about $153 per share. Thus, you can short 17,117 shares of SPY ($2,619,000 / $153) to hedge your sample portfolio.
• Sector-specific ETFs: If you are trying to hedge an individual stock, you may want to utilize a sector-specific ETF to achieve our risk management objectives. For example, I own CVS Caremark (CVS Quote). CVS is a component stock in the Retail Holdrs ETF (RTH Quote). I could hedge out some of my CVS risk by short-selling the RTH.
• Inverse and levered inverse ETFs: Whole new classes of negative correlating ETFs have been recently listed. These ETFs allow you to buy downside protection in an index. Using the SPY as an example, the Short S&P 500 ProShares (SH Quote) and the Ultra Short S&P 500 ProShares (SDS Quote) will appreciate as the SPX declines and will decline when the SPX increases. The SDS provides a double leverage impact on movements in the SPX.

As with the use of futures, ETFs will provide imperfect hedges and could result in adding more risk rather than reducing risk to your portfolio. (To learn more about ETFs, visit TheStreet.com's ETF Center.)

5. Options

Options are the most complex tool available for hedging ("Options: Getting Started"). Options require an intimate knowledge of the non-linear aspects of options pricing in order to effectively execute hedge and manage risk.

Options require a much more detailed explanation before one can integrate their use into risk management. I will, however, state that you can consider one of three strategies:

• Selling covered calls: Selling a call against the position you desire to hedge.
• Buying puts: Buying put protection or insurance against your holding(s).
• Collaring: Simultaneously selling a covered call and buying a put to lock in a minimum and maximum potential sales price.

(To learn more about options, check out TheStreet.com Options Alerts.)

Your Homework

1. Identify a stock or stocks which could be sold short as a hedge against an individual holding

2. Calculate the risk of your portfolio and determine how many futures or ETFs are necessary to hedge the portfolio

3. Become more familiar with inverse and leveraged inverse ETFs

As always, you can email me your homework and thoughts on the subjects covered in this or previous articles. I will compile the best ideas in a future module of TheStreet.com University.