Finance Professor: Five Hedging Techniques You Must Know

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: