Hedging appears to be simple in practice. If you are long on a stock, then you can either sell equivalent futures or you can just buy a put option. In case you are cautiously optimistic on the stock then you can reduce your cost of put hedging by selling a higher call option. All that is fine as long as the stock is available on F&O. But there are just about a little over 200 stocks in F&O and there are over 400 stocks that are listed. How do you hedge a stock that is not there in F&O? There are 3 ways to do it.
Hedge risk through diversification
This is the easiest form of diversification. By creating a portfolio of around 10-15 stocks with low correlations with each other, you can diversify your risk. Diversification helps to spread risk by adding stocks with lower correlation. Stocks have a systematic and unsystematic component to their risk. 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. This may not be applicable if you are just holding on to a couple of stocks and are looking to hedge the same.
Hedge with similar correlation profiles
The second way to hedge in such cases is to sell futures or buy a put option on another stock in similar business having a very correlation with the stock. For example, a small steel stock may not be available in F&O but the stock may have historically displayed a very correlation in price movements with Tata Steel. In such cases, one can look to hedge by selling equivalent futures of Tata Steel. However, it needs to be remembered that this is an imperfect hedge and if any correlation shift occurs then this hedge may actually become invalid. For example, Dewan Housing may have had a high correlation with HDFC and is also in the same industry. But once the liquidity issues became clear at DHFL, its price performance diverged from the rest of the stocks and at that point of time such a correlation hedge would not have worked.
Beta Hedge with the Nifty
This is the most comprehensive and scientific approach to hedging risk through selling of Nifty futures. This would also apply more for a portfolio than for individual stocks. Let us first understand what exactly is Beta? Beta is a measure of systematic risk, which is the risk that cannot be diversified away. A beta of more than 1 means that it is an aggressive stock and a beta of less than 1 means that it is a defensive stock. The beta of an index like Nifty or the Sensex is always 1. How would Beta hedge work really work?
Here is a portfolio of 5 non-F&O stocks
The above portfolio of non-F&O stocks is worth Rs.22.30 lakhs. Each stock has a beta based on past price data. In the above portfolio, all stocks are aggressive stocks with Beta more than 1. That means even the portfolio beta will be more than 1. Let us see how this works out to calculate the portfolio beta.
Calculating the portfolio beta…
Portfolio beta is nothing but the weighted average of individual stock betas. How do we calculate the weights of various stocks? It represents the relative weight of the stock in the index. In the above example if all the 5 stocks are weighted to the overall portfolio and then the weighted beta is calculated for each stock, then the total portfolio beta comes to 1.2622. This is the basis of beta hedging.
How to do Beta hedging
In the above case we know that the portfolio value is Rs.22.30 lakhs and that the weighted beta of the portfolio is 1.2622. Here is how to do beta hedging!
Calculation for beta hedging
Value of the Portfolio – Rs.22,30,000/-
Weighted beta of portfolio – 1.2622
Value of Futures to be shorted – Rs.28,14,706 (22,30,000 x 1.2622)
Since the value of 1 lot of Nifty futures (lot size 75) is Rs.820,950 you need to sell 3.43 lots (28,14,706 / 8,20,950). Since you cannot sell fractional lots, you can sell either 3 or 4 lots of Nifty to hedge your non-F&O portfolio. This choice can be based on your view.