Contract Notional Value

The contract unit represents the standardized size of a futures contract, which can be based on weight, volume, or financial measurement. For instance, the contract unit for a COMEX Gold futures contract (GC) is 100 troy ounces, while the NYMEX WTI Crude Oil futures contract unit (CL) is 1,000 barrels of oil. The E-mini S&P 500 futures contract unit (ES) is determined by a financial calculation based on a fixed multiplier times the S&P 500 Index.

The contract notional value is the financial expression of the contract unit and the current futures contract price. To calculate the notional value, multiply the contract unit by the futures price. For example, if Gold futures are trading at $1,000, and the contract unit is 100 troy ounces, the notional value would be $100,000.

Notional values are useful for determining hedge ratios against other futures contracts or related underlying markets. For instance, if a portfolio manager has a $10M U.S. equity market exposure, she can use the notional value of E-mini S&P 500 futures to determine a hedge ratio. To calculate the hedge ratio, divide the value at risk by the notional value. If the E-mini S&P 500 futures have a notional value of $106,000, the hedge ratio would be approximately 94 contracts to hedge the market risk.

Mark-to-Market

Mark-to-market (MTM) is a critical aspect of futures trading, whereby the daily settlement price is determined and applied uniformly across all market participants. Prior to regulatory reforms after the 2007-2008 financial crisis, over-the-counter (OTC) forwards and swaps did not have an official daily settlement price, which left clients uncertain about their daily variation. In contrast, futures markets have an official daily settlement price established by the exchange, and the methodology used is fully disclosed in the contract specifications and exchange rulebook.

For instance, CME Globex determines the daily settlement price for corn futures based on trading activity in the last minute of trading between 13:14:00 and 13:15:00 Central Time (CT), while the daily settlement price for E-mini S&P 500 futures is determined by a volume-weighted average price (VWAP) of all trades executed in the full-sized, floor-traded futures contract and the E-mini futures contract for the designated lead month contract between 15:14:30 and 15:15:00 CT. The daily settlement price for U.S. Treasury futures is established based on trading activity on CME Globex between 13:59:30 and 14:00:00 CT, even though trading continues until 4:00 p.m. CT the following day.

The final daily settlement price is used to report trades, calculate daily profit/loss, and, if necessary, adjust margin requirements. Losers must pay winners every day, and any losses or profits are not carried forward but must be resolved daily. If an account’s losses cause the net equity to fall below exchange-established margin levels, additional financial resources must be provided to replenish the amount back to the required levels or risk liquidation of the position.

Mark-to-market ensures the daily discipline of exchange profit and loss between open futures positions, eliminating any loss or profit carry forwards that might endanger the clearinghouse. The exchange’s publication of these daily settlement values provides an invaluable service to commercial and speculative users of futures markets and the underlying markets from which they derive their price.

Margin: Know What’s Needed

Margin is a concept that is used in multiple financial markets, including securities and futures. When you buy securities on margin, you borrow money as a partial down payment, up to 50% of the purchase price, to own the stock, bond, or ETF. In contrast, futures margin refers to the amount of money you must deposit and keep on hand with your broker when opening a futures position. It is not a down payment, and you do not own the underlying commodity.

The percentage of margin required for futures contracts is generally lower, ranging from 3-12% of the notional value of the contract. Margin requirements can change based on market conditions and the clearinghouses’ margin methodology. When markets are volatile, margin requirements may be raised to account for increased risk, while they may be lowered when conditions warrant.

There are two types of futures margin: initial margin and maintenance margin. The former is the amount required by the clearinghouse to initiate a futures position, and your broker may require additional funds for deposit. The latter is the minimum amount that must be maintained in your account at any given time.

If your account falls below the maintenance margin level, you may receive a margin call, where you will be required to add more funds immediately to bring the account back up to the initial margin level. If you cannot or do not meet the margin call, you may be able to reduce your position based on the amount of funds remaining in your account, or your position may be automatically liquidated once it falls below the maintenance margin level.

It is essential to understand the differences between securities margins and futures margins before trading futures contracts. While margin is a useful tool to increase buying power, it also carries risks, and proper risk management is crucial.

Understanding Futures Expiration & Contract Roll

The Duration of Futures Contracts

When trading futures, it’s crucial to understand the limited lifespan of each contract, which can affect your trading strategy and exit plan. Two significant terms to consider are expiration and rollover.

Expiration Options A futures contract’s expiration date is the last day of trading for that particular contract. Although it typically falls on the third Friday of the expiration month, it may vary depending on the contract.

Traders have three options before expiration:

Offset the Position Offsetting or liquidating a position is the most common and straightforward way of closing out a trade. Traders can realize profits or losses associated with the position without receiving the underlying asset or cash.

To offset a position, a trader must execute an equal and opposite transaction to nullify the trade. For instance, a trader who is short two WTI Crude Oil contracts expiring in September must buy two WTI Crude Oil contracts of the same expiration date. The difference in price between the initial and offset positions indicates the profit or loss.

Rollover When rolling over, traders transfer their positions from the current contract to a future contract with a later expiration date. Traders may decide when to switch to the new contract by monitoring the volume of both the current and the next month’s contracts. Once the volume reaches a certain level in the next contract, a trader may opt to roll over their position.

To roll over, a trader must simultaneously offset their existing position and establish a new position in the next contract month. For example, a trader who is long four S&P 500 futures contracts expiring in September would sell four Sept ES contracts while buying four Dec or later ES contracts.

Settlement If a trader has not offset or rolled over their position by the contract’s expiration, the contract will expire, and settlement will take place. A short trader must then deliver the underlying asset according to the original contract’s terms. Depending on the market, this could be in the form of physical delivery or cash settlement.

Managing Your Futures Positions As the expiration date approaches, it’s vital to decide how to handle your trades in terms of rollover and expiration. Your choices may significantly impact the outcome of your trades.