Stock trading can help you build wealth gradually and create an adequate corpus. But it takes years of practice and experience to become a successful stock trader. You must have sufficient knowledge about various stock trading strategies and know the different jargons associated with trading. Notional value is one such term you will regularly hear during the stock trading process. So let’s find out what does notional value mean.
What is a notional value?
Notional value, also referred to as notional amount is a stock-trading term often used in the context of valuing the underlying assets during a derivatives trade. It could be the total value of a given position, the amount of value controlled by a position or an agreed-upon, predetermined, amount in a contract. Typically, the term notional value is used to describe derivative contracts in futures and options and currency markets.
Difference between notional value vs market value
Notional value is a theoretic value that represents the value of a position or portfolio. It depicts how much money a security controls. It is used for risk assessment, portfolio management as well as trading derivatives (futures and options). It can also be used to calculate the value on which interest payments will be exchanged.
Market value represents the actual current price of an investment or asset based on various market forces and other factors. Market value is the price at which a particular security can be traded in the market. It serves as a key indicator of an asset’s worth at a given point in time. It can also be used to represent a company’s worth at a particular time.
Decoding notional value
Having explained what is a notional amount or value, let’s understand it from the context of the stock market. Notional value is simply the total amount of derivatives trading. The notional amount or value of a derivatives contract is typically much higher than its market value, owing to a trading concept known as leverage.
Leverage and notional value
Leverage in notional value enables traders to use a smaller amount of money to control a significantly larger amount. As such, notional value assists in distinguishing the total value of the trade from its market value, i.e. the price at which a position may be purchased or sold in the market. The amount of leverage you can utilise is calculated as under:
Leverage = Notional Value/ Market Value
Now, stock trading contracts typically have a standardised, unique size which is based on several essential factors including volume, weight and multipliers. For instance, a single Gold Futures Contract could be of 3000 grams (weight), while an S and P index futures contract would have a Rs. 3,500 multiplier. In this example, the notional value of the gold futures is 100 times the market price of the gold, whereas the notional value of the index future is Rs. 3,500 times the S and P index’s market price. Thus, the notional amount or value is calculated as under:
Notional value = Contract Size x Underlying Price
Notional value uses
Notional values are used for various purposes as follows:
1. Equity Options
Notional value in equity options depicts the value that a particular position the option controls. This can help in assessing the potential risk that the particular position an option holds.
2. Interest Rate Swaps
In interest rate swaps, notional value is the key to calculating the value on which the interest rate payments will be exchanged. This helps the investor know the amount of interest due as well as the counterparty risk.
3. Total Return Swaps
Under this, one party pays a fixed or floating interest rate to the other party, which is multiplied by the notional amount plus depreciation. The notional value in total return swaps, facilitates hedging, speculation as well as risk assessment.
Final note
Now that you have a preliminary understanding of what does notional amount mean; you can research it in detail. Contact our team of experienced investment advisors at Angel One for more information on notional trading.
