InvestorQ : I am having a portfolio of stocks that are not there in F&O. Is it possible to hedge these stocks and how to do it?
Dilmini Mercia made post

I am having a portfolio of stocks that are not there in F&O. Is it possible to hedge these stocks and how to do it?

Dhwani Mehta answered.
3 years ago

You are correct that hedging cannot be as perfect as a stock that is in F&O because in that case the hedge can almost be 1:1. This problem can be quite acute because there are only 200 stocks in F&O and more than 4500 stocks that are not there in F&O. However, even if you are holding stocks that are not there in F&O or even if you a portfolio that is full of non-F&O stocks you can still hedge your risk. Here are some ways you can hedge your risk in such cases.

a) The easiest way to hedge your risk of non-F&O stocks is through creating a diversified portfolio. How do you go about this? This appears to be the simplest form of diversification but actually even this can quite complex. The best way is to create a portfolio of around 10-15 stocks with low correlations with each other. Diversification helps spread risk by adding stocks with lower correlation. If you add two closely related stocks then there is hardly any diversification. To give you an example, RIL and gold are a diversification game.

b) Stocks have systematic and unsystematic risk components. While the systematic risk or market risk cannot be diversified, the unsystematic risk can be reduced or minimized by diversification. This is the most basic form of risk hedging and it only works at a portfolio level and not at an individual stock level.

c) Another way to hedge non-F&O stocks is to select an F&O stock that has a very high correlation with the stock you are looking to hedge. For example, a small cement stock may not be available in F&O but the stock may have displayed a very high correlation in price movements with Ultratech. In such cases, you can hedge by buying put options of Ultratech. Remember that this is an imperfect hedge and is prone to risk.

d) Finally, you can also Beta Hedge with the Nifty, in case you have a portfolio of such non-F&O stocks. This is a comprehensive and scientific approach to hedging risk through selling of Nifty futures. Again this would only apply to a portfolio and not so much for individual stocks. Beta hedging is done by using Beta, which is a measure of systematic risk, which is the risk that cannot be diversified away. A beta of more than 1 means it is an aggressive stock and a beta of less than 1 means it is a defensive stock. The beta of Nifty or Sensex is always 1. Now let us say, your portfolio value of non-F&O stocks is Rs.20 lakhs and the beta of your portfolio is 1.1, so you need to sell Rs.22 lakhs worth of Nifty futures ((20 lakhs * 1.1) to get a beta hedge.

It is possible to hedge your non-F&O portfolio, although it will always be an imperfect hedge. Beta hedge is expensive and should only be done if the portfolio is large enough.