An offset is a powerful financial market strategy that requires a trader to take an opening position and then take a directly opposite position. For example, if you are long 100 shares of XYZ, selling 100 shares of XYZ would serve as the offsetting position.
Offsetting positions can also be generated through hedging instruments such as futures or options. In the derivatives markets, offsetting a futures position involves entering an equivalent but opposite transaction that eliminates the delivery obligation of the physical product it represents.
The goal of offsetting is to reduce an investor’s net position in an investment to zero, so that no further gains or losses are experienced from that position.
In business, an offset refers to generating gains in one business unit to make up for losses in another unit.
Key Takeaways
- In accounting, an offset is the recording of a gain that nullifies the effect of the recording of a loss.
- An offset in futures trading involves taking two opposite positions on a commodity to cancel the delivery of the commodity.
- In various markets, offset strategies are used to reduce exposure to risk.
How an Offset Works
Offsetting finds applications in several types of businesses, aiming to remove or limit liabilities.
- In accounting, an entry can be offset by an equal but opposite entry that nullifies the original entry. For example, a loss in one division can be eliminated by an equal profit in another division.
- In banking, the right to offset offers financial institutions the ability to seize debtor assets in the case of delinquency.
- For investors in the futures market, an offsetting position eliminates the need to receive physical delivery of the underlying asset or commodity by selling the associated goods to another party.
Offsetting Losses
Businesses may offset losses in one division by reallocating gains from another. This allows the profitability of one activity to support another activity.
For example, a business that succeeds in the smartphone market may decide to enter the tablet market. The profits from smartphone sales can help offset the early losses associated with expanding into a new arena.
Similarly, companies with global sales may offset losses in one currency with gains in another. One unit may have risk exposure due to a decline in the Swiss franc compared to the euro, while another may benefit from a declining franc.
Offsetting in Derivatives Contracts
Investors offset futures contracts and other investment positions to extricate themselves from any associated liabilities. Almost all futures positions are offset before the terms of the futures contract are realized. This ensures that the benefits of the futures contract as a hedging mechanism are still achieved, even if most positions are offset near the delivery term.
A futures contract is an agreement to purchase a particular commodity at a specified price on a future date. If a contract is held until the agreed-upon date, the investor might need to accept the physical delivery of the commodity in question.
The purpose of offsetting a futures contract, for most investors, is to avoid the physical receipt of goods associated with the contract.
Offsetting to Reduce Risk
In the options markets, traders often offset certain risk exposures, sometimes referred to as their Greeks. For instance, if an options book is exposed to declines in implied volatility (long vega), a trader may sell related options to offset that exposure.
Or, if an options position is exposed to directional risk, a trader may buy or sell the underlying security to become delta neutral. Dynamic hedging (or delta-gamma hedging) is a strategy employed by derivatives traders to maintain offsetting positions on an ongoing basis.
Why Take an Offset Position?
One definition of the word offset is “something that serves to counterbalance or to compensate for something else.” In all contexts where offsets are used, they aim to eliminate a loss or some other downside risk inherent in a previous decision.
What Does It Mean to Offset a Payment?
An offset in a payment is a reduction in the total amount owed. It occurs when one party successfully argues that the amount due should be reduced due to some compensation owed to the payer.
What Is a Tax Refund Offset?
If your tax refund is offset, it means the federal government has seized a portion of your refund to put towards a state or federal debt you owe. For example, unpaid child support can trigger this action.
The Bottom Line
If the initial investment was a purchase, a sale in the same amount is made to neutralize the position. To offset an initial sale, a purchase is made to neutralize the position.
With futures related to stocks, investors may use hedging to assume an opposing position to manage the risk associated with the futures contract. For example, if you want to offset a long position in a stock, you could short-sell an identical number of shares.
Related Terms: hedging, derivatives, futures contracts, options, liabilities.
References
- U.S. Securities and Exchange Commission. “Form 40-F Blackberry Ltd”.
- USA.gov. “What to do if your tax refund is lower than expected”.
