What Is a Cylinder?
In finance, "cylinder" is a term used to describe a transaction, or series of transactions, that does not require any initial or ongoing cash investment. The term is most commonly used in derivative transactions, such as in forex or options markets.
- A cylinder is a type of financial transaction in which the investor does not contribute any initial cash.
- Cylinders are often associated with transactions involving derivative products, such as options.
- Although cylinder transactions do not require upfront cash, the investor effectively pays for the position by assuming financial risks. Consequently, cylinder transactions are not risk-free investments.
Financial derivatives are a mechanism by which two or more parties can carry out transactions in which they exchange the financial risks associated with different kinds of assets. Critically, derivative transactions do not require either party to own or take possession of the underlying assets in question.
For example, one of the largest financial risks faced by investors is the risk of currency fluctuations. Companies and individuals alike hold significant exposure to currency risk in the form of inventory, bank deposits, and financial assets denominated in various currencies. These actors can hedge against these risks by using derivative products, such as currency futures and forward contracts. Traders can also speculate on currency movements using these same instruments.
Many of these transactions do not require the participants to exchange cash when the contract is initiated. Instead, the value of the contract will fluctuate based on the shifting value of the underlying assets, and the parties will exchange cash at the end of the contract based on the change in value of those assets.
In other cases, premiums will be paid upon initiation of the contract, although these payments are modest compared to the total value of the contract. For instance, when buying a call option the investor will pay a premium to the option seller. However, this premium is generally small compared to the value of the underlying assets represented by the option.
Because of these factors, it is possible for an enterprising trader to put together an investment, or a series of investments, in which no initial outlay of capital is required, and in which the gains from each investment are continuously reinvested in subsequent trades. Of course, this strategy may not succeed, and the failure of the strategy could ultimately be quite costly.
Real World Example of a Cylinder
Emma is an options trader who wishes to construct a cylinder trade involving shares in XYZ Corporation, which is currently trading for $20 per share.
To accomplish this, she starts by selling a put option against XYZ shares. The put option has a strike price of $10 and expires in one year. This means that for the next year, the holder of the option has the right to sell 100 shares of XYZ to Emma for $10 a share. Naturally, the option holder would only exercise this right if the market price of XYZ declines below $10. In exchange for making this commitment to the option holder, Emma receives a $5 premium.
With this premium in hand, Emma's next step is to buy a call option against XYZ shares. The option she chooses has a strike price of $30 and an expiration date one year in the future. If the price of XYZ shares rises above $30, then Emma can exercise her option, buying shares at the $30 strike price and selling them at the higher market price, thereby obtaining a profit. In exchange for this right, Emma pays a $5 premium to the option seller. Because Emma had already received $5 from selling the put option beforehand, her net cash investment is $0.
If we look back on Emma's transactions, we can see that she has structured a cylinder transaction with no upfront cost to herself. She now has a derivative position in XYZ stock, which she obtained without expending any in cash.
It is important to note however that just because the position did not require cash upfront, this does not mean that Emma is obtaining a risk-free profit. Instead, what has actually happened is that Emma has "paid" for the XYZ position by accepting financial risk. Specifically, she has assumed the liability of being responsible to sell XYZ shares at a loss if their price declines below $10 per share. In exchange, she earned the right to buy XYZ shares at a profit if their price rises above $30.
Clearly, an investor would only assume this position if they believe that XYZ shares are more likely to rise above $30 than to decline below $10 during the time horizon of the investment. In other words, Emma will only assume this position if she is bullish on XYZ shares.