What Are Hedging Techniques?

hedging-techniques Credit: Jose Luis Pelaez Inc/Blend Images/Getty Images

Hedging techniques are strategies and tactics employed by investors to reduce financial risk. Pairing, short-against-the box, exchange-traded funds, futures and options are the most commonly used to predict and reduce financial risk.

Hedging is ultimately a financial strategy used to reduce risk, according to Forbes. The first technique, called pairing, involves offsetting a position with a similar, but not identical, security risk. The first step in this process requires investors to identify certain characteristics and elements of a specific corporation relevant to its risk profile. These factors include industry and sector categorization, market capitalization, beta profile, dividend yield and stability estimates based on historic trends.

Short against the box, or SATB, is another technique employed to avoid capital gains taxes on low-cost basis holdings. SATB, however, is a short-term strategy and a relatively risky tax-avoidance strategy. The technique of futures involves analyzing a portfolio of stocks for its ability to reduce future risk. Using sector-specific exchange-traded funds, or ETFs, may help investors achieve some risk management objectives and reduce future risk by providing a means of purchasing downside protection. However, using ETFs carries some risk, and may ultimately increase potential harm to a portfolio over time. Lastly, options employ one of three strategies: selling covered calls, buying puts and collaring to reduce financial risk over time.