Finance Professor: Five Hedging Techniques You Must Know

So far I have discussed how to identify risk and how to manage risk. Now it's time to get a little more sophisticated and explore hedging techniques.

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.