Risk is what a market is all about: Taking it on and hedging against that uncertainty. Sure, you can use ETFs to jump quickly into complex markets, such as the best Polish stocks or a basket of high-dividend-paying issues. Now it’s time to look at ETFs from the hedging side when you invest .

On The Move

Exchange traded funds hook into a maze of trading, including on the floor of the New York Mercantile Exchange. View Enlarged Image

The most active ETF is the SPDR S&P 500 (ARCA:SPY ). No wonder. This instrument gives you an instant position in that major stock index. Short it, and you’re a stock market bear.

Now let’s see how you can lay off risk. Say you have a $100,000 portfolio of stocks, and you want to protect the whole basket from a broad-market correction.

You could sell the portfolio, but it includes some big winners.

You may be near the one-year holding period for the lower (not low enough!) long-term capital gains tax rate. Anyway, it took you a long time to put this together.

Fine. Hold on, and let ETFs help you.

First, determine the beta of your portfolio. The beta tells you how much a stock or a group of stocks, like your portfolio will move, given a certain movement in the S&P 500. So if your portfolio has a beta of 1.5, you know that a 1% move in the S&P 500 either way should yield a 1.5% move in your portfolio, give or take the usual statistical deviation parameters.

Next, protect that portfolio. The SPDR S&P 500 ETF trades at 169. Sell short the appropriate number of shares to hedge your winners against a market swoon. This is especially easy to do, as the Spiders trade 112 million shares on an average day. That’s vast liquidity.

What’s the appropriate number of shares? You may think 592 ($100,000 divided by 169). Wrong. You’ll need to short 888, because your stocks will likelier fall 50% harder than the S&P 500.

Maybe your needs are more short-term. Maybe the Federal Reserve is about to announce the results of one of its policymaking meetings.

That can be a grueling few days.

Consider that options on the SPDR S&P 500 ETF trade on the Chicago Board Options Exchange. Here, too, volume is huge, making for top-notch liquidity of any equity-related option.

Buy some puts, or sell some calls, or do both. Consider that your portfolio may be full of stocks that carry no options, or have maddeningly low option liquidity. If you know your beta, you can use the ETF options market to protect your portfolio during that queasy period.

Straddling

Now let’s look at how ETFs can put you into one risk position while laying off another. You have a choice of ETFs that will give you a long position in a foreign country’s stock market while avoiding that country’s currency. WisdomTree Japan Hedged Equity (ARCA:DXJ ) ETF reflects the action of a basket of Japanese dividend-paying stocks. What’s special? The ETF hedges the yen position, letting you easily buy into Japanese stocks without being forced to own yen.

A global version of this product appears as WisdomTree Europe Hedged Equity Fund (ARCA:HEDJ ) ETF. Despite the name, this ETF includes some holdings from Japan and Australia. It offers a dividend yielding 1.8%.