What is Notional Value? | Understanding Notional Value
Mar 4, 2016
Notional value tells us how much total value a security theoretically controls.
Standard equity option contracts control 100 shares of an underlying. The notional value of these option contracts is 100 times the current market price of the underlying.
Contract Size * Underlying Price = Notional Value
If we purchase an at the money (ATM) call trading for $2.00 in XYZ while XYZ is at $30.00, the notional value of the option will be $3,000.00 (100 shares the option controls * $30.00 price of the underlying).
Alternatively, the market price of an option contract is how much it currently trades for in the market. In the above example, the ATM call has a market price of $200.00 (100 shares the option controls * $2.00 price of the option contract).
100 Shares the Option Controls * Option Price = Option Market Price
The notional value for option contracts is higher than the option market price we pay because options use leverage.
Leverage means we are able to use less money (less buying power) to theoretically control 100 shares of stock compared with buying the 100 shares outright. The amount it costs to buy 100 shares outright is the notional value of the option contract.
To calculate how much leverage an option gives us, we divide the notional value of the option by the option’s market price. The earlier long call example had a notional value of $3,000.00 and cost us $200.00, giving us fifteen times notional leverage on our money ($3,000.00 / $200.00 = 15).
Futures contracts are notionally very large and are not typically traded in smaller accounts. Unlike standard equity options, the number of contracts controlled by a futures contract changes depending on the underlying. Below is a chart listing the notional value of some common futures.
In the chart, we see a column listed as “$/Point.” What this column means is for a $1.00 price change in the underlying the futures contract will gain (or lose) the listed amount of money.
Looking at “/CL” we not only see that crude oil has gone down a lot in price (oil is ~$30.00 a barrel at the time of this blog post), but we also see that a $1.00 price change in oil leads to an oil futures contract gaining or losing $1,000.00. At the time of the pictures' creation, the price of oil was $97.42, giving one /CL contract a notional value of $97,420.00.
Instead of trading large futures contracts in a smaller account, we can trade smaller notional ETFs that similarly track the futures underlyings (ex. SPY, USO, GLD, and UNG).
Knowing the notional value of a position helps us understand the risk in our portfolio and how to size our trades.
When we look to trade an underlying, we need to take into account not only the initial cost to place the trade, but also the potential risk associated with the trade.
Although a trade may only require a small amount of buying power to place initially, that can change if the underlying moves against us.
For example, looking at the above futures chart, we see that a $4.00 change in oil can lead to a $4,000.00 fluctuation in our account for one /CL futures contract. If our account is too small or we are not ok with that size fluctuation, we may want to look for smaller underlyings that can give us similar exposure with a smaller notional value, like USO.
A short put in a margin account may only require around 20% of its strike price in buying power, but we need to understand that our losses are not limited to this 20% figure and that the buying power required may increase if the trade moves against us.
Notional value can seem intimidating, but by adjusting our trade sizes (staying small and increasing our occurrences) and with appropriate strategy selection, we can use our understanding of notional value to improve our trading.
Stock price: $1,288.42
Notional value of the call option: $128,842.00
Market price of the call option: $5,740.00
Have questions about notional value? Email us at email@example.com
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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