What is an Offsetting Transaction
In trading, an offsetting transaction is an activity that exactly cancels the risks and benefits of another instrument in a portfolio. The trader uses it when it is not possible to only close or end the original transaction, as desired. Being unable to close a position frequently happens with options and other more complex financial trading instruments.
In this way, a trader is free to essentially end a trade without having to acquire consent from the other parties involved. While the original trade still exists, there is no longer an effect on the trader from market moves and other events.
BREAKING DOWN Offsetting Transaction
A basic example of an offsetting transaction occurs in options trading. Assume you sold a call option on 100 shares with a strike price of $35 with an expiration of three months. To close this transaction before the three-month period, you can buy a call option with the same features, thus precisely offsetting the exposure to the original call option. What you do not do is repurchase the options position from the exact person who bought it from you in the first place.
It is a subtle difference, but since options and most other financial instruments are fungible, meaning that it does not matter which specific instrument is involved, as long as they all have the same issuer, strike, and maturity features. For bonds, as long as the issuer, insurance, coupon, call features, and maturity are the same, the specific bond involved does not matter.
What is important is that the trader ends their financial interest in what happens to the instrument.
Offsetting Complex Transactions
The process of neutralizing a position becomes a bit more involved in more exotic markets, such as with swaps. With these specialized, over-the-counter transactions, there is no ready liquidity to merely buy or sell the equivalent but opposite instrument. To offset a position here, the trader must create a similar swap with another party. Counterparty risk may not be the same, although all parties may agree to the same terms and conditions as the original swap.
There are other imperfect offsetting transactions, including holding short and long positions in spot and futures markets. In this case, the spot position is more or less "clean," while the futures position has variables including a changing premium to the spot price. Indeed, the premium can go negative under certain conditions. And finally, other traders may have strategies in place to exploit the approaching maturity date that may affect futures pricing.