What it means
Traders unwind a position when they close it by doing the opposite trade. If a fund bought 10,000 shares, it unwinds by selling the same 10,000 shares, and the profit or loss is locked in.
The word is also used for large investment strategies that are wound down, such as when many investors close the same leveraged trade at once. In derivatives, to unwind a contract means to end it before its natural expiry.
The two parties agree a termination payment that reflects the value of the remaining contract, with the party that is better off being paid by the other. For an interest rate swap, that payment is based on the present value of the expected future payments, which are discounted back to today.
Businesses also unwind deals. A merger can be unwound if a regulator or a court orders the combined companies to separate, and a structured finance arrangement can be unwound when its purpose ends.
In each case the work involves reversing legal agreements, transferring assets and settling money between the parties. Accountants use a related phrase, unwinding of the discount.
When a long-term provision or liability is recorded at its present value, the carrying amount rises each year as time passes, and the increase is booked as a finance cost. This is a gradual accounting effect, and not a decision to reverse a deal.
Unwinding is rarely free. Trading costs, bid-ask spreads, termination fees and market moves can all reduce the result, and forced unwinding in a falling market can cause losses.
Careful planning, including how much time is needed to exit, is part of managing risk. Documentation is a further point.
Before closing a large position, firms agree who will execute it, at what pace and with what limits, and they record the reasons. That record helps explain the result to investors, auditors and regulators afterwards.
In practice
Real-world examples.
Example
A portfolio manager decides that a trade on the price of oil no longer makes sense and unwinds it by selling her futures contracts. She locks in the profit made so far. The remaining margin deposit is released back to her account.
Example
A manufacturer enters a five-year interest rate swap to fix its borrowing cost, then repays the underlying loan after two years. It unwinds the swap by paying the bank a termination amount of $85,000, which reflects the change in interest rates since the swap began.
Example
A competition authority orders a company to unwind its recent purchase of a competitor. The company must sell the acquired business to a new owner and pay the costs of the separation. Finance staff track the legal fees and the loss on sale.
Formula
Calculation
Gain or loss on unwinding = (exit price - entry price) x quantity - costs
Suppose a fund bought 10,000 shares at $50 each, a cost of $500,000. It unwinds the position by selling at $54, so the proceeds are 54 x 10,000 = $540,000. Trading costs for the sale are $200. Gain on unwinding = (54 - 50) x 10,000 - 200 = 40,000 - 200 = $39,800.Case study
Seen in the real world.
Redwater Capital is an illustrative, fictional hedge fund that held a large position in a thinly traded bond. When rumours of a downgrade began, the fund's risk manager decided to unwind the $30,000,000 holding.
Selling all of it at once would have pushed the price down, so the team sold in slices over ten days. Each day moved the price by a small amount, and the average sale price was 1.5% below the opening price, a cost of 30,000,000 x 0.015 = $450,000.
A competing fund that waited lost far more when the downgrade came. The illustrative lesson is that unwinding has a cost, but a planned, gradual exit usually costs less than a forced one. The risk manager also kept a log of every slice sold, so the board could see how the plan had been carried out.
Watch out
Common mistakes.
- Assuming that unwinding a position is free, when trading costs, spreads and market impact all reduce the result.
- Forgetting that unwinding a derivative requires a termination payment that can be large and may go either way.
- Confusing unwinding of the discount with reversing a transaction, when the accounting term describes the gradual build-up of a present-valued liability.
Questions
People also ask.
Is unwinding the same as selling?
Selling is one way to unwind a long position, but unwinding is the broader idea of reversing any trade, contract or deal.
Why do many investors unwind at the same time sometimes?
When prices fall, lenders can demand more collateral, which forces investors to sell, and the selling pushes prices down further.
Who decides the price of unwinding a swap?
The two parties agree it, usually based on market rates and the dealer's valuation of the remaining payments.
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