For example, a typical futures contract for crude oil involves 1,000 barrels of oil. If one barrel currently costs $70, the notional value of that contract is: 1,000 x $70 = $70,000 The generic formula for calculating the notional value of a derivatives contract is: Units of the underlying asset in a contract x Value of one unit = Notional value
How Does the Notional Value of Derivatives Work?
The notional value of a derivative expresses the overall value of the assets involved in the contract. This makes notional value a useful metric because it lets investors quickly understand the value of the assets in the contracts they are buying or selling. Notional value commonly comes into play when investors are trying to hedge their portfolios. For example, let’s take the E-mini S&P 500 futures contract. Each unit of this contract is equal to $50 multiplied by the value of the S&P 500 index. Suppose the S&P 500 index is at 4,000; the notional value of one E-mini S&P future contract would be $50 x 4,000 = $200,000. Now imagine an investor who has $10 million invested in a diversified portfolio of U.S. stocks. They want to hedge their portfolio against a major downswing in stock prices. The investor might use E-mini S&P 500 futures contracts to hedge their investments. If the notional value of one S&P 500 futures contract is $200,000, to fully hedge their portfolio, the investor needs to sell: $10 million / $200,000 = 50 contracts The price of the 50 contracts will be much less than $10 million, but the notional value is what lets the investor understand how much of the underlying asset those contracts will involve.
Notional Value vs. Intrinsic Value
Notional value and intrinsic value are two measures of value that derivatives traders frequently use, but each term describes very different things. For example, an options contract typically involves 100 shares of a stock. If XYZ is trading at $10, one contract for XYZ has a notional value of $1,000 because it controls $1,000 worth of XYZ stock. If an investor owns a put option on XYZ with a strike price of $11, the intrinsic value of that contract is $100 because they could exercise the contract to buy shares at a $100 discount to their market price. While notional value lets investors know how many contracts they’d need to buy to hedge a position of a specific size, intrinsic value helps investors calculate the profit they could realize by exercising the contract. It, along with time value, is also one of the primary determinants of an option’s market value.
What It Means for Individual Investors
Most individual investors likely aren’t investing in large enough amounts that they’ll feel the need to significantly hedge their portfolios. However, if you’re trading options or other derivatives, notional value may be useful because it can help you measure trade volume. The more notional value traded in a specific derivatives market, the higher the trade volume of those contracts tends to be. If you want to trade highly-liquid derivatives, looking at notional value can help you find the options, futures, and other derivatives to trade.
