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What is Notional Value and How Does it Work?

What is notional value?

In the financial markets, notional value refers to the amount of money controlled by a given financial position. Notional value is commonly cited in derivatives markets, because these instruments allow for considerable leverage. 

An awareness of notional value allows investors and traders to easily differentiate between the cost to enter a given position and the total financial value that is controlled by that position. The cost to enter a position may be referred to as the market value, which is the price that a financial security (such as a derivative) can be bought and sold.

From that perspective, market value refers to the actual value of a securities position, whereas notional value refers to the total financial value controlled by that position.

How does notional value work?

In the derivatives markets, notional value represents the scale or size of a position without indicating the actual amount of money transacted to enter a given position. 

In a futures contract, the notional value is the product of the number of units of the underlying asset and the specified contract price. For example, a futures contract for 1,000 barrels of oil at $60 per barrel would have a notional value of $60,000.

In an options contract, the notional value is the underlying asset's market price multiplied by the contract's specified amount. If one option contract represents 100 shares of a stock trading at $50, the notional value would be $5,000.

For swaps, two parties might exchange interest rate payments based on a notional principal amount. This amount is the reference upon which interest rate payments are calculated. However, the notional principal doesn't typically change hands.

How to calculate notional value

To calculate notional value, one simply multiplies the current market price of the underlying asset by the number of units (or shares) each option contract represents, and then by the total number of contracts held. Typically, one equity option contract represents 100 shares of the underlying stock, so if you hold a n option on a stock priced at $50, the notional value of a single contract would be $5,000 (i.e., $50 x 100 x 1 = $5,000). 

It’s important to keep in mind that the notional value can vary for other types of options, such as those on futures or indices, depending on the specific terms of the contract and the multiplier used.

Notional value in options explained

In the options market, notional value represents the total exposure of the position, offering insight into the amount of the underlying asset that the options contract controls. 

To calculate notional value, one simply multiplies the current market price of the underlying asset by the number of units (or shares) each option contract represents, and then by the total number of contracts held. Typically, one equity option contract represents 100 shares of the underlying stock, so if you hold a n option on a stock priced at $50, the notional value of a single contract would be $5,000 (i.e., $50 x 100 x 1 = $5,000). 

It’s important to keep in mind that the notional value can vary for other types of options, such as those on futures or indices, depending on the specific terms of the contract and the multiplier used.

While the premium (or cost) to enter an options position might be relatively small, the notional value can be much larger, underscoring the leverage inherent in derivatives trading. An understanding of notional value can therefore help investors/traders better understand and manage risk. 

Notional value example

Two examples are shown below that provide further detail on how to calculate notional value. 

Equity Options

Imagine an investor buys 5 call option contracts on a stock. Each option contract represents 100 shares. Assuming the current market price of the stock is $50/share, notional value is calculated as follows: 

  • Notional Value = Number of contracts × Shares per contract × Stock Price

  • Notional Value = 5 × 100 × $50 = $25,000

  • That means the investor essentially controls $25,000 worth of stock with those 5 call options.

Learn what options are and how they work.

Futures

Imagine an investor enters into a futures contract to buy 10 contracts of gold. Each contract is for 100 ounces of gold. Assuming the current market price of gold is $1,500/ounce, notional value is calculated as follows: 

  • Notional Value = Number of contracts × Ounces per contract × Gold Price

  • Notional Value = 10 × 100 × $1,500 = $1,500,000

  • That means the investor essentially controls a gold position with a notional value of $1,500,000.

Learn what futures are and how they work.

Notional value vs market value: what are the differences?

Market value refers to the actual value of a securities position, whereas notional value refers to the total financial value controlled by that position.

Why is notional value important?

Notional value is a key metric in the derivatives markets, representing the total exposure/value of a derivative position, such as an option or future. For investors and traders, the notional value illuminates the scale/size of a position, detailing the amount of the underlying asset that the derivatives position controls. 

While the capital required to enter a derivatives position (like the margin in a futures contract or the premium in an options contract) may be just a fraction of the notional value, the potential profit or loss from price movements is based on this larger notional amount. As such, the notional value offers a more comprehensive view of the position's true scale, rather than just the initial capital outlay.

Considering the aforementioned information, one can see how an understanding of notional value is so critical for effective position and risk management. Using the notional value, investors and traders can better gauge their potential exposure and set appropriate stop-loss, hedging, or diversification strategies. This market awareness also allows market participants to recognize the full extent of their market exposure, allowing for more informed decision-making. 

Leverage in Options

When it comes to options, leverage works a little differently. Unlike stock, available buying power doesn’t change. If we deposit $10,000 into my account, our option buying power will be $10,000. If we are in a margin account, the stock buying power will be $20,000. That is how the stock leverage works.

If we’re in a margin account and have full margin for options, the difference lies in the buying power reduction (BPR).

Let’s say we sell a put at the $50 strike, when the stock price is trading at $55.00. In an IRA account, which is cash secured and has no leverage, we would be required to put up $5000, less the credit we receive for selling the put. Each put contract has the theoretical equivalent of 100 shares of long stock, which is why the shares are already accounted for when selling the put.

In a margin account, however, we would only be required to put up a fraction of the total value. In a lot of cases, it may be around 20% of the strike (around $1000 in this case). There are a few different calculations the brokerage works through, and they choose the highest value of those calculations for BPR. This is where leverage plays a role. We are only required to put up $1000 initially, but we still stand to lose $5000 less the credit received if the stock price goes to $0.00. This is why we always keep a lot of cash available in our portfolio, as these margin requirements can change by the minute.

Leverage in Futures

Leverage is generally highest in futures products. Take /CL for example, which is the light sweet crude oil futures contract. This product trades for $1000 a point. That’s right, $1000 a point! If we own a futures contract, and /CL is up $1.00, we would see a gain of $1000. That means that in order to find the notional value, we’d have to multiply the current price by 1000. If /CL is trading at $47, the notional value of one contract is $47,000.

In a margin account, the cost to purchase one contract is only about $3,500 at that price! That means the investor is getting over 10:1 leverage on that contract, when you look at notional value vs buying power required to purchase the contract. All futures products are different, so it’s extremely important to understand the notional value & point value for futures contracts that you’re trading.

Leverage comes in all shapes and sizes. More leverage can give us a higher return on capital, as we’re not required to put up as much, but it can also magnify losses quickly. Understanding leverage and how we can use it is imperative for futures, options, and stock traders alike.

Notional value summed up

In the financial markets, notional value refers to the amount of money controlled by a given financial position. Notional value is commonly cited in derivatives markets, because these instruments allow for considerable leverage. 

Leverage allows investors and traders to control a large financial position with a relatively small amount of capital. In this context, the notional value represents the value of that larger position. 

An awareness of notional value allows investors and traders to easily differentiate between the cost to enter a given position and the total financial value that is controlled by that position. The cost to enter a position may be referred to as the market value, which is the price that a financial security (such as a derivative) can be bought and sold.

From that perspective, market value refers to the actual value of a securities position, whereas notional value refers to the total financial value controlled by that position. 

To calculate notional value, one simply multiplies the current market price of the underlying asset by the number of units (or shares) each option contract represents, and then by the total number of contracts held. Typically, one equity option contract represents 100 shares of the underlying stock, so if you hold a n option on a stock priced at $50, the notional value of a single contract would be $5,000 (i.e., $50 x 100 x 1 = $5,000). 

It’s important to keep in mind that the notional value can vary for other types of options, such as those on futures or indices, depending on the specific terms of the contract and the multiplier used.

Using notional value, investors and traders can better gauge their potential exposure and set appropriate stop-loss, hedging, or diversification strategies. This market awareness also allows market participants to recognize the full extent of their market exposure, allowing for more informed decision-making. 

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