Offsetting Transaction - Explained
What is an Offsetting Transaction?
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Table of ContentsWhat is an Offsetting Transaction?How Does an Offsetting Transaction Work?Offsetting Complex Transactions
What is an Offsetting Transaction?
An offsetting transaction is a term used in trading that nullifies the benefits and risks associated with another instrument or security in a portfolio. It is often used when it is beyond control to end the actual transaction as per the wish. This activity is used in options and many other complicated trading instruments when it becomes impossible to end a position. A trader doesn't have to ask for permission from the associated parties in order to close a transaction. It has no effect on the actual trade and the trader owing to market conditions and other situations.
How Does an Offsetting Transaction Work?
The concept of offsetting transaction takes place in options trading. For instance, Mr. A sold a call option of 100 shares at a strike price of $35 with a maturity of 3 months. If he wants to end the transaction before the maturity period, he has the opportunity to buy a call option having the same attributes, thereby offsetting or balancing the exposure to the original or basic call option. However, he wont be buying those options again from the same person who purchase it from him initially. Options are freely exchangeable or fungible (stating that it has nothing to do with a particular instrument till the issuer, strike price and maturity attributes are similar). In case of bonds, the type of bond involved doesn't matter till the issuer, coupon, insurance, call features and maturity dates match. It is important to note that the trader closes his/her monetary interest in what happens with the financial instrument.
Offsetting Complex Transactions
Stock markets dealing in swaps have more probabilities of balancing out or offsetting a position. The special over-the-counter transactions are readily illiquid for trading the equivalent but contrasting instrument. For the purpose of offsetting a position in this case, the trader must devise a swap of similar nature with the other party. There can be a difference in counterparty risk. However, it is possible that all parties are willing to abide by the similar terms and conditions as mentioned in the original swap. Holding short and long positions in futures and spot markets are considered as some of the imperfect offsetting transactions. In such cases, the spot position is somewhat clean, while the futures position consists of variables that include a fluctuating premium to the spot price. Also, the premium can undergo the risk of being negative in some situations. Other traders may use strategies to utilize the coming maturity date that can have an impact on futures pricing.