What is Unwinding a Position?

To unwind is to close out a trading position, with the term tending to be used when the trade is complex or large. Unwinding also refers to the correction of a trading error, since correcting a trading error may be complex or require multiple steps or trades. For example, a broker mistakenly sells part of a position when an investor wanted to add to it. The broker would have to unwind the transaction by first buying the sold shares and then purchasing the shares that should have been purchased in the first place.

Basics of Unwind

Unwinding is used to refer to the closing trades that require multiple steps, trades, or time. If an investor takes a long position in stocks while at the same time selling puts on the same issue, they will need to unwind those trades at some point. This entails covering the options and selling the underlying stock. A similar process would be followed by a broker attempting to correct a buying/selling error.

Unwinding is a process of reversing or closing a trade by participating in an offsetting transaction.

Closing a Position

Closing a position is the process required to eliminate a particular investment from a portfolio. In the case of securities, when an investor wants to close the position, the most common action is to sell the security. In the case of shorts, an investor would need to buy the short shares back to close the position. The term unwinding is more likely to be used when the buying or selling occurs over multiple transactions, and not just one. Unwinding is a process.

Unwinding to Correct Trade Errors

If a broker accidentally performs an incorrect action with an investor's funds, such as buying more of a particular security when the instruction was to sell it, the broker must resell the security that was accidentally purchased to correct the error. They must then make the original sale requested. If the broker experiences a loss during this error correction process, the broker is responsible for the difference, not the investor.

Other activities that can be considered a trade error include buying or selling a security other than the one specified, buying or selling the incorrect quantity of a security, or trading in prohibited securities. Errors that are caught prior to being fully processed, and that are successfully canceled, do not require unwinding.

Unwinding and Liquidity Risk

Liquidity risk can have negative effects on an investor's or a broker's ability to unwind a transaction. Liquidity refers to the ease at which a particular asset can be bought or sold. If an asset is less liquid, it is more challenging to find an appropriate buyer or seller, so the liquidity risk is elevated. Regardless of whether a transaction was completed intentionally or accidentally, all risks associated with the particular security still apply when attempting to unwind it.

Key Takeaways

  • To unwind a position is to close it out.
  • Generally large and complex trades are candidates for unwinding a position. In some cases, the unwind strategy is also used to correct trade errors.