Introduction of Lot Size in Futures
Futures trading and lot size are closely linked. The lot size plays a crucial role as it sets the minimum quantity of an underlying asset that can be traded in a futures contract. This has significant implications for pricing, liquidity, and margin requirements. By standardizing the quantity of the underlying asset, the lot size promotes fair and transparent pricing in futures trading. Moreover, it also determines the margin requirements for trading futures.
What is Lot Size?
Lot size in futures trading refers to the minimum quantity of shares required to trade. It sets the basis for buying and selling items in minimum lots or multiples of the lot size when engaging in futures and options trading.
The lot size determines the minimum amount needed to purchase futures and options contracts. Traders can buy several stock futures based on the lot size or multiples. The lot size establishes the foundation for futures and options contracts, providing a standardized framework for trading.
What makes it different from other measures of trade size, such as units or shares, is that lot sizes are specific to futures trading, whereas units and shares are used in other types of trading. Additionally, lot size is predetermined and standardized by the futures exchange, whereas the number of units or shares traded can vary based on the specific trade.
Why Lot Size is Important?
By standardizing the lot size, futures exchanges can ensure that all traders buy and sell the same quantity of the underlying asset in each contract. This helps to promote transparency and efficiency in the market, as traders can easily compare prices across different contracts.
Another reason why lot size is important in futures trading is that it determines the margin requirements for trading futures. The margin requirement is typically a percentage of the total value of the futures contract, which is determined by the lot size. This means that larger lot sizes require higher margin requirements, affecting the number of capital traders needs to trade futures. Several case studies demonstrate why lot size is important in futures trading. Let’s take a look at the examples:
Case Study – Chicago Mercantile Exchange (CME)
The CME is one of the world’s largest futures exchanges, and it uses standardized lot sizes to ensure fair and transparent pricing. For example, the lot size for a corn futures contract is 5,000 bushels, which means that all traders on the exchange must buy or sell at least 5,000 bushels of corn for each contract.
Case Study – New York Mercantile Exchange (NYMEX)
The NYMEX, known for its energy futures contracts, demonstrates the significance of lot size in trading. Let’s consider the lot size for a crude oil futures contract, which is typically 1,000 barrels. This means that traders must transact at least 1,000 barrels of crude oil in each contract. By standardizing the lot size, the NYMEX ensures consistent trading quantities, facilitating fair pricing and market transparency for all participants.
Case Study – E-mini S&P 500 Futures
The E-mini S&P 500 futures contract is traded on the Chicago Mercantile Exchange (CME) and has a lot size of 50 units of the S&P 500 index. This lot size determines the minimum quantity of the index that can be bought or sold in a futures contract. The standardized lot size allows for easy comparison of prices and efficient trading among market participants. It also affects margin requirements, as traders must meet the specified margin amount based on the lot size to participate in the market.
How to Calculate Lot Size in Futures?
Step 1 – Gather the necessary information
To calculate the lot size in futures, you need to know the contract size (quantity of the underlying asset represented by each futures contract) and the tick size (minimum price movement) of the futures contract. For example, let’s consider trading corn futures on the Chicago Mercantile Exchange, where the contract size is 5,000 bushels, and the tick size is 1/4 cent per bushel. Additionally, determine the maximum amount of money you’re willing to risk on the trade, let’s say $500.
Step 2 – Determine the tick value
The tick value represents the monetary worth of the price change. Multiply the contract size by the tick size to calculate the value of one tick. In our example:
1 tick = 1/4 cent per bushel
The value of 1 tick = contract size x tick size
Value of 1 tick = 5,000 (contract size) x 1/4 cent per bushel = $12.50.
Step 3 – Compute the stop loss level
To determine the number of ticks for your desired stop loss level, divide the maximum risk amount by the value of one tick. For instance:
Maximum risk = $500
Number of ticks = Maximum risk / Value of 1 tick
Number of ticks = $500 (maximum risk) / $12.50 (value of 1 tick) = 40 ticks
Step 4 – Convert the stop-loss value to the desired currency
If needed, convert the stop loss value from points (ticks) to the desired currency using the current market price. Let’s assume the current market price of corn futures is 100 euros per bushel. The stop loss value in points is 40 ticks as calculated in step 3. Now, you need to convert 40 ticks to euros. So, the calculation will be as follows:
Multiply the number of ticks (40) by the tick value ($12.50): 40 x $12.50 = $500 Find the exchange rate from dollars to euros (let’s assume it’s 1 dollar = 0.85 euros) Multiply the dollar value of the stop loss by the exchange rate: $500 x 0.85 = 425 euros The stop-loss value for this trade is 425 euros.
Step 5 – Determine the appropriate lot size
To calculate the lot size, divide the permissible risk by the product of the price per contract (tick size multiplied by contract size). For instance: Price per contract = 1/4 cent per bushel x 5,000 bushels = $12.50. Lot size = $500 (permissible risk) / ($12.50 x 5,000 bushels) = 0.008 contracts. Round up the lot size to the nearest whole number if necessary. In this case, it would be one contract, which is equivalent to 5,000 bushels of corn.
In futures trading, lot size plays a crucial role as it represents the minimum quantity that can be bought or sold in a single contract. Its importance lies in determining margin requirements and promoting fair pricing. By standardizing lot sizes, exchanges ensure that all traders trade the same quantity, fostering transparency and equal opportunities. Calculating the lot size involves considering factors such as risk level, tick value, and the stop-loss level. By maintaining consistent lot sizes, futures exchanges provide traders with a clear understanding of their trade commitments. Lot size acts as a fundamental aspect of futures trading, ensuring fairness, transparency, and informed decision-making.