Hedging is about protecting any kind of risk; be it downside risk, concentration risk, volatility risk etc. That is simple if the stock is available on F&O. But there are just about 200 stocks in F&O and there are over 4500 stocks that are listed on the BSE. The big question therefore is; how to hedge a stock that is not there in F&O? You can adopt either of the three ways.

Diversify your portfolio to reduce risk

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.

Use futures in stocks with similar correlation

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.

There is also a third method called beta hedging that involves weighting the portfolio by its beta and then hedging the risk but it is a lot more complicated.