DEFINITION of 'Cylinder'
A cylinder is a term used to describe a transaction involving derivatives. As a part of the transaction, the investor does not incur an initial cost; this can be demonstrated through the sale of one derivative and using the proceeds to buy a different derivative. As the transaction does not require any additional investment to complete, the transaction is defined as a cylinder.
BREAKING DOWN 'Cylinder'
Financial derivatives are a mechanism by which two or more parties can trade certain financial risks without necessarily trading the asset upon which the risk is based. Such risks may include currency risks, credit risks or commodity price risk. While some financial derivative trading utilizes offsetting contracts, it is not specifically inherent to a cylinder trade. A cylinder is similar to a positive carry but does not inherently involve an offsetting position.
Example of a Cylinder
A cylinder transaction does not require the addition of a new financial investment for completion. Instead, it can be completed through the use of a multi-stage transaction. The simplest of cylinder transactions can be completed in two stages. The first stage involves the sale of a currently held investment, such as a derivative. This sale releases the monetary investment, allowing the funds to be reinvested. If these funds are reinvested during the second stage, such as through the purchase of a different derivative, the transaction is completed without the need for the investor to contribute any additional funds. Therefore, no initial cost is experienced by the investor for the transaction to be completed. This process could be repeated as necessary to proceed with new transactions in the future.
An offsetting contract involves entering into a contract that yields opposite results when compared to the initial contract. Such transactions minimize risk when the original investment cannot be canceled. For example, if Company X purchases 100 shares at a price of $5 per share, an offsetting transaction involves the ability to sell the same 100 shares at a price of $5 per share. These two positions inherently negate each other and eliminate the risk involved in the first transaction.
Positive and Negative Carries
If an offsetting position is in place, these carries can be either positive or negative in nature. A positive offset exists when the gain being produced by one position exceeds the losses of the other. A negative carry results when the gains on one position are not enough to offset the losses of the other.