How to Hedge: Indevus Pharmaceuticals

In a broad sense, diversification is a sort of natural hedge. Think about it - by investing in a diverse range of stocks, you're limiting the risk that any one position will hurt your overall portfolio. But that's just the tip of the iceberg; there are many more ways to hedge that are more effective.

Learning to Hedge With Indevus Pharmaceuticals

Let's take a look at a real hedging scenario. Indevus Pharmaceuticals (IDEV Quote) took a big hit on Wednesday -- a 65% tumble. That makes this stock a great example of how to hedge.

For starters, let's say that you're worried that the biotech industry is a little too volatile right now. If you want to protect an investment against turbulence in an industry, one of the simplest ways is by shorting an index fund or industry exchange-traded fund (ETF) or if you want to avoid margin, just buying a short ETF (see "How Short ETFs Make Money").

For example, you could just take a short position in the iShares NASDAQ Biotechnology Index (IBB Quote), and be shielded from an industry-wide loss. That's the kind of hedge that would have saved your shirt if you were a Yahoo! (YHOO Quote) shareholder when the technology bubble burst in 2000.

But that would not have been a good hedge for Indevus.

Assuming you have done your homework, you would know that Indevus is a small-cap drug company that's working on developing a couple of new drugs. Sound like risky territory? It turned that it was. News about Federal Drug Administration (FDA) approval for one of the company's drugs caused this week's sharp drop in stock price, but the rest of the industry didn't budge.