Finance Professor: Five Hedging Techniques You Must Know

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.