How to Trade Day 5
What is a Contract Unit?
Definition: A contract unit is the specific amount or size of the asset that is covered by a futures contract. This unit is standardized, meaning everyone who trades that contract uses the same size.
Examples of Contract Units:
Gold Contract: In the COMEX (a commodity exchange), one Gold futures contract (symbol: GC) represents 100 troy ounces of gold. This is measured by weight.
Crude Oil Contract: For the NYMEX (another commodity exchange), one WTI (West Texas Intermediate) Crude Oil futures contract (symbol: CL) is 1,000 barrels of oil. This is measured by volume.
S&P 500 Contract: The E-mini S&P 500 futures contract (symbol: ES) doesn’t have a fixed unit of measure like weight or volume; instead, its value is calculated based on the S&P 500 Index and a multiplier.
2. What is Contract Notional Value?
Definition: The contract notional value is the total value of the futures contract based on the contract unit size and the current price of the asset.
How to Calculate Notional Value:
To find the notional value, you multiply the contract unit by the current futures price.
Formula:
Notional Value = Contract Unit × Current Futures Price
3. Examples of Calculating Notional Value:
Example 1: Gold Futures Contract
Contract Unit: 100 troy ounces
Current Price: $1,000 per ounce
Calculation:
Notional Value=100 (troy ounces)×1,000 (price)=100,000Notional Value=100(troy ounces)×1,000(price)=100,000
So, the notional value of the Gold futures contract is $100,000.
Example 2: WTI Crude Oil Futures Contract
Contract Unit: 1,000 barrels
Current Price: $50 per barrel
Calculation:
Notional Value=50 (price)×1,000 (barrels)=50,000Notional Value=50(price)×1,000(barrels)=50,000
So, the notional value of the WTI Crude Oil futures contract is $50,000.
Example 3: E-mini S&P 500 Futures Contract
Contract Unit: Uses a multiplier of $50
Current Price: 2,120.00 (this is the index value)
Calculation:
Notional Value=50 (multiplier)×2,120.00 (index value)=106,000Notional Value=50(multiplier)×2,120.00(index value)=106,000
So, the notional value of the E-mini S&P 500 futures contract is $106,000.
4. Why Are Contract Unit and Notional Value Important?
Understanding Risk: Notional values help traders understand the total exposure (risk) they have in the market.
Calculating Hedge Ratios: Notional values are also used to determine hedge ratios. A hedge ratio shows how many contracts you need to buy or sell to protect against market risks.
5. What is a Hedge Ratio?
Definition: The hedge ratio is a way to figure out how many futures contracts you need to trade in order to protect (or hedge) against potential losses in your investments.
How to Calculate Hedge Ratio:
The formula is:
Hedge Ratio=Value at RiskNotional ValueHedge Ratio=Notional ValueValue at Risk
Example of Hedge Ratio Calculation:
Let’s say a portfolio manager has $10 million exposure to U.S. equities (stocks).
Value at Risk: $10,000,000
Notional Value of E-mini S&P 500 futures: $106,000
Calculation:
Hedge Ratio = 10,000,000 / 106,000 ≈ 94.34
This means the portfolio manager would need to sell approximately 94 E-mini S&P 500 futures contracts to effectively hedge against market risk.
Conclusion
In summary, understanding contract units and notional values is crucial for anyone trading futures. These concepts help you grasp the size of the contracts you are dealing with and the overall risk involved in your trading strategies. Knowing how to calculate the hedge ratio allows traders to protect their investments more effectively.
Key Terms to Remember:
Contract Unit: The standardized size of a futures contract (e.g., 100 troy ounces for gold).
Notional Value: The total value of a futures contract (calculated as contract unit × current price).
Hedge Ratio: A measure to determine how many contracts to buy/sell to protect against losses.
