Square-off of options

Just like a futures position, an interest rate option position does not have to be carried to expiry either. It can be squared off — closed by trading the opposite side of the same option contract — at any point while it is open.

What the square off actually realises is the change in premium between the entry trade and the closing trade — not the option's payoff at expiry, which may never happen if the position is closed early.

The workbook's example (Chapter 21, section 21.8.5): a dealer hedging a bond holding buys put options at one premium, then later decides to cancel the option before expiry by selling it back at whatever premium then prevails. The net pay-off is simply:

Net gain / (loss) = (Premium received on square off) − (Premium originally paid)

Why square off rather than hold to expiry: the underlying exposure the option was hedging may itself have ended, so the option is no longer needed — exactly the situation in the workbook's example, where the dealer sold the underlying G-Secs before the option's expiry and only then squared off the option position.

On 1 October, a dealer hedges a Rs 100 crore G-Sec holding by buying 5,000 lots of an October-expiry 6.10% GOI 2031 put option at a strike of Rs 101.00, with the option then priced at Rs 0.20/0.21 (bid/offer). He pays the offer price:

Premium paid = 5,000 × Rs 0.21 = Rs 1,050

On 15 October he sells his underlying G-Secs, so the hedge is no longer needed. He squares off the option position the same day, at a prevailing price of Rs 0.10/0.11, receiving the bid:

Premium received = 5,000 × Rs 0.10 = Rs 500
Net gain / (loss) = 500 − 1,050 = (Rs 550)

The dealer realises a Rs 550 loss on the option itself — but this is the cost of insurance that was never claimed on, not evidence the hedge failed. The option protected the bond holding for the fifteen days it was actually needed; the Rs 550 is simply what that protection cost, net of what was recovered by exiting early rather than letting the option run to a worthless or in-the-money expiry.

Chapter 21 (Exchange Traded Interest Rate Options), section 21.8.5, works through squaring off an option position with the Rs 550 net loss calculation, immediately after covering long and short put payoffs. Expect a computation question giving premium paid and premium received on square off, asking for the net gain or loss.

• Squaring off realises the change in premium, not the option's expiry payoff. A position closed early never gets to whatever intrinsic value it might have reached by expiry.
• A loss on squaring off an option used as a hedge is not the same as the hedge failing. The workbook's dealer squares off at a loss precisely because the hedge worked and the protection was no longer needed.
• Buying back an option to square off means paying the current offer; selling one to square off means accepting the current bid — the bid-offer spread itself is a cost of squaring off early.
• This mechanism applies to options, distinct from squaring off a futures position, though the underlying idea — an opposite trade to close the exposure — is the same.