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.
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
Apart from futures and options contracts, notional value is also used for interest rate swaps, currency swaps and equity options. The notional value, in case of interest rate swaps, is specified upon interest rate payments to be exchanged. Total return swaps, on the other hand, involve parties paying a fixed or floating interest rate which is multiplied by the notional amount, plus the reduction in notional value. In the case of equity options, the notional value is the value controlled by options.
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.