What is Notional Value and How Does it Work?

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.

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.

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 an option on a stock priced at $75, the notional value of a single contract would be $7,500 (i.e., $75 x 100 x 1 = $7,500). 

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.

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. For example, a short put contract at the $100 strike price on XYZ stock has a notional value of $10,000 (i.e., $100 x 100 x 1 = $10,000). 

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. This is especially true for short options, where a short put mimics the intrinsic value risk of 100 shares of stock, and a short call has unlimited notional value to the upside with no cap on how high a stock price can go. An understanding of notional value can therefore help investors/traders better understand and manage risk. 

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.

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

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. 

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. For equity options, this means multiplying the strike price by 100. If I sell a put with a strike price of $30 on XYZ stock, my notional value exposure is $3000 (i.e., $30 x 100 x 1 = $3,000). 

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.