Cylinder

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. 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. 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. 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. 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.

A cylinder is a transaction in which the investor doesn't contribute cash initially.

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.

Understanding Cylinder

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.

Cylinder Example

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.

Related terms:

Bank Deposits

Bank deposits are money placed into a deposit account at a banking institution, such as savings accounts, checking accounts and money market accounts. read more

Bull

A bull is an investor who invests in a security expecting the price will rise. Discover what bullish investors look for in stocks and other assets. read more

Call Option

A call option is a contract that gives the option buyer the right to buy an underlying asset at a specified price within a specific time period. read more

Contract Size

Contract size is the deliverable quantity of commodities or financial instruments that underlie futures and options contracts traded on an exchange. read more

Currency Futures

Currency futures are a transferable contract that specifies the price at which a currency can be bought or sold at a future date.  read more

Currency Risk

Currency risk is a form of risk that arises from the change in price of one currency against another. Investors or companies that have assets or business operations across national borders are exposed to currency risk that may create unpredictable profits and losses. read more

Derivative

A derivative is a securitized contract whose value is dependent upon one or more underlying assets. Its price is determined by fluctuations in that asset. read more

Forward Start Option

A forward start option is an exotic option that is bought and paid for now but becomes active later with a strike price determined at that time. read more

Forward Contract

A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. read more

Inventory :

Inventory is the term for merchandise or raw materials that a company has on hand. read more