What is a Cylinder
A cylinder is a term used to describe a transaction involving derivatives. As a part of the transaction, the investor does not incur additional costs for new trades taken. An example is the sale of one derivative, then using the proceeds to buy a different derivative. Since the transaction does not require any additional investment to complete, the transaction is defined as a cylinder.
Breaking Down the Cylinder
Cylinder trades, often used in the derivative market, don't necessarily involve an offsetting transaction.
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.
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 are 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, there is no additional cost to the investor for the transaction to be completed. This process could be repeated as necessary to proceed with new transactions in the future. The cylinder can continue as long as the funds received continue to roll into a new investment.
In this example, there would would have been an initial outlay of cash to attain the first position. Therefore, while the a cylinder may be the plan all along, there needs to some sort of initial transaction or cash outlay for a derivative which gets the cylinder started.
An offsetting contract involves entering into a trade that yields opposite results when compared to the initial trade. Such transactions minimize risk when the original investment cannot be canceled. For example, if an investor purchases 100 shares at a price of $5 per share, an offsetting transaction involves the ability to sell the same 100 shares. These two positions inherently negate each other and eliminate the risk involved in the first transaction. While offsetting transactions will occur, the objective of the cylinder is to roll funds from one investment into another.