What Is a Cylinder?
In finance, "cylinder" is a term used to describe a transaction, or series of transactions, that don't require an initial or ongoing cash investment. The term is most commonly used in derivative transactions in forex or options markets.
- A cylinder is a transaction in which the investor doesn't contribute cash initially.
- Cylinders are often associated with transactions involving derivative products like options.
- Although cylinder transactions don't require upfront cash, they aren't risk-free.
With derivatives, two or more parties exchange the financial risks associated with different kinds of assets. Critically, derivative transactions don't require either party 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. They can hedge against currency fluctuations by using derivative products like currency futures and forward contracts. These instruments can also be used to speculate on currency movements.
Many of these transactions don't require participants 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, an enterprising trader might 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 would ultimately be costly.
An options trader wishes to construct a cylinder trade involving shares in XYZ Corporation, which is currently trading for $20 per share.
To accomplish this, they start 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 the option seller for $10 a share. Naturally, the option holder would only exercise this right if the market price of XYZ declines below $10 plus the premium they paid. In exchange for making this commitment to the option holder, the writer receives a $5 premium.
With this premium in hand, the writer's next step is to buy a call option against XYZ shares. The option they choose has a strike price of $30 and an expiration date one year in the future. If the price of XYZ shares rises above $30 plus the premium they paid, they can exercise this 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, they pay a $5 premium to the seller of this option. Since they had already received $5 from selling the put option beforehand, their net cash investment is $0.
Essentially, the option trader has structured a cylinder transaction with no upfront cost to themselves and now has a derivative position in XYZ stock without expending any cash.
The trader isn't guaranteed a risk-free profit, despite putting up no cash upfront. Instead, what has actually happened is that they "paid" for the XYZ position by accepting financial risk. Specifically, they assumed the liability of being responsible to buy XYZ shares at a loss if their price declines below $10 per share. In exchange, they 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, they will only assume this position if they are bullish on XYZ shares.