What is an Offsetting Transactions?

The financial landscape is constantly evolving. This makes effective risk management necessary for all market participants—from individual traders to mid-size companies and large financial institutions. Many tools are available out there that help manage risk. One such tool is offsetting transactions. An offsetting transaction is a position or transaction taken in the opposite direction of the original position or transaction. In this article, we take a deep dive into offsetting transactions and see how they are helpful in trading and accounting.

How Offsetting Works in Trading and Accounting?

Offsetting or an offset transaction is a useful tool in trading and accounting. Using this tool, traders can take a position in the opposite direction of the original position to mitigate risks.

It is commonly used in derivative contracts and helps traders eliminate the obligation to take physical delivery of securities.

For example, a trader has bought 1,000 shares of ABC. To mitigate the risk of loss and reduce exposure, the trader takes an offsetting position by selling or shorting 1,000 shares of ABC.

An offset transaction cancels out the original position or transaction and reduces the risks arising from it. Since the offset position is in the opposite direction, in an ideal transaction, it should result in no gains or losses from the original position.

In accounting, an offset transaction is an entry that offsets or cancels out another entry of similar value.

For example, if one entry shows a loss of Rs 1 lakh, another entry showing a profit of Rs 1 lakh can be considered an offset transaction.

Businesses make use of offset transactions to cancel out losses of one unit or division with the gains in another unit or division.

Common Use Cases of Offsetting Transactions

Offsetting transactions are typically used while trading in derivative contracts like futures contracts. A trader in a futures contract has the obligation to deliver or take delivery of the underlying asset. With the help of an offsetting transaction, the trader can eliminate this liability.

Additionally, offsetting transactions help in hedging. By taking on an offset position, a trader can reduce the market exposure and mitigate the losses caused by the original position. Traders also utilise options Greek to deploy various strategies that can help offset positions and reduce risk.

Businesses also benefit from offsetting transactions, as they help set off losses. An offset transaction can help set off losses arising from business expansion or losses due to currency exchange rates.

Examples of Offsetting in Futures & Options

Here are some examples to help understand how offsetting transactions work in futures & options (F&O).

An offset position in futures can help eliminate the liability of having to take physical delivery of the underlying asset, such as a commodity.

For example, a trader has bought 10 lots of cotton futures. The futures contract is held till the expiry date, and upon expiry, the trader is obligated to take delivery of the commodity. However, the trader takes an offsetting position by selling 10 lots of cotton futures. Since the original position is offset by selling the same quantity, the trader is no longer obligated to take delivery of the commodity.

Offset transactions are also used while trading options to reduce risk. Several factors, including options Greek, are considered while creating strategies to offset the original position and thus, mitigate losses. Let’s look at an example.

A trader has an options position in a stock. The stock is expected to move in a particular direction, exposing the options position to risk. The trader can buy or sell the underlying security to offset the options position and reduce the risk. Similarly, when the implied volatility of options contracts is expected to decline, the trader can sell the related options contracts to offset the risks arising from a decline in the implied volatility.

Also Raed : What is Physical Delivery in Commodity Trading?

Benefits of Offset Transactions

The following are some benefits of offset transactions:

• Help in effectively managing risks.
• They can be used in businesses to offset losses arising from expansion, currency fluctuations, or losses arising in the normal course of business.
• Traders can make use of offset transactions to navigate volatile market conditions while maintaining their positions.
• Offset transactions offer flexibility, allowing traders to adapt to a variety of situations.

Limitations of Offset Transactions

• Since offset transactions take a position in the opposite direction of the original position, they can limit any potential gains.
• Offset transactions carry transaction costs such as brokerage fees and taxes.
• In case the price movements are erratic and the offset position does not move accordingly, it can lead to losses.
• It requires regular monitoring and management.

Tax Implications

In accounting, offsetting is commonly seen when losses from one head are set off by gains under another head. India’s tax laws lay down detailed provisions for setting off profits and losses arising from different businesses.

For example, a loss arising from a long-term investment can be set off against long-term capital gains only and not against short-term capital gains.

Similarly, there are guidelines for setting off profits and losses from speculative businesses, professions and businesses. Losses that are not offset in the same year can be carried forward to subsequent years.

Offsetting vs Closing Position

Although an offset position and a closing position may seem similar, they differ from each other. When a trader offsets a trade, a position in the opposite direction is opened, without closing the original position. On the other hand, when a trader closes a trade, the position is closed, and the profit or loss arising from the position is finalised.

Summary and Best Practices

An offset transaction has several advantages for traders and businesses. By taking a position in the opposite direction or through counterbalancing transactions, a position or transaction can be offset. Offsetting helps traders effectively manage risk. However, one needs to monitor the position and be aware of the associated costs.