Editor's Note: This story was originally published June 20, 2003 on RealMoney

You can use exchange-traded funds to reduce some of the systematic risk in your portfolio, a notion I discussed in another column. I've already explored some of the benefits -- and limitations -- of using ETFs as a hedge, so let's delve a little further into the mechanics of how this trade works.

The first question, of course, is how to choose the appropriate ETF to use. This really depends on the level of protection you desire, which will be a recurring theme throughout this column. For example, every U.S. stock has some correlation to the S&P 500, although obviously to varying degrees. So, to some extent, S&P Depositary Receipts ( SPY), also known as SPDRs, could be used as a hedge and would provide some protection, particularly for the large-cap universe.

Now, if you're long a micro-cap value stock, shorting SPDRs most likely won't offer you ample protection because there's probably a low correlation between this hypothetical micro-cap value stock and the S&P 500, as the S&P 500 index is made up of large-cap stocks. Also, the micro-cap stock may be illiquid, in which case larger orders would move the stock disproportionately one way or the other.

With the advent of sector-specific HOLDRs (which are holding company depositary receipts -- technically not ETFs, but very similar instruments) and iShares (a category of ETFs), it's sometimes possible to find an ETF that matches up well with the underlying stock position that you want to hedge.

For example, shorting the Biotech HOLDRs ( BBH) may be an effective hedge against a long Amgen ( AMGN) position. In the same thread, Internet HOLDRs ( HHH) may be able to hedge eBay ( EBAY), and Pharmaceutical HOLDRs ( PPH) could be used to reduce some systematic risk inherent in Johnson & Johnson ( JNJ). The greater the correlation between the ETF and the stock, the better hedge the ETF will provide. The easiest way to determine this (for liquid, large-cap stocks) is to look for the corresponding sector-specific ETF.

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