The term contract size refers to the deliverable quantity of a commodity or security named as the underlying asset in a futures or options contract. The deliverable quantity, and therefore the contract size, for futures and options contracts are standardized but vary according to the underlying asset.
Before we delve into how option contract sizes are standardized, how they work in practice, as well as their advantages and disadvantages, let’s start with the basics.
Derivatives Trading & Contracts
The term ‘derivative’ refers to a financial contract set between two parties who use them to trade different securities across markets. The value of a derivative contract depends and fluctuates based on an underlying benchmark, which can be assets, including but not limited to stocks, bonds, commodities, or a group of assets.
Traders use derivatives for two main reasons:
To mitigate risk (hedging) – achieved by going short on an asset without closing a long position; and/or
To speculate on the price movement of an asset.
These contracts can be bought and sold on exchanges as well as over-the-counter (OTC).
How does an options contract work?
Options offer the buyer the opportunity, but not the obligation, to buy or sell the chosen underlying asset at a predetermined price set out in the contract, either within a certain timeframe or at the expiration date.
A call option gives the holder the right to buy the underlying asset, whereas a put option allows them to sell it.
The terms of an options contract specify the following:
The underlying security; stocks, bonds, commodities, and so on;
The price at which that security will be bought or sold, called the strike price; and
The expiration date of the contract.
How does a futures contract work?
Future contracts work similarly to options contracts. The striking difference is that they are legally binding. When entering a futures contract, the buyer must purchase, or the seller must sell the underlying asset at the set price, regardless of the current market price, at the expiration date.
Both futures and options contracts are standardized in order the streamline trade facilitation.
Understanding Option Contract Size & Standardization
In simple words, the standardization of derivative contracts refers to a uniform set of guidelines. It aims to ease the way both parties interact and transact with each other. These guidelines include the following:
Expiration dates,
Delivery methods,
Delivery options,
How the price is determined, and
The contract size.
The contract size is an important variable to understand when entering into an options or futures contract. It refers to the amount of underlying asset that is included in the contract.
In essence, it helps determine which players can enter the contract. Larger contract sizes typically denote participation by institutional investors, whereas smaller contracts are more accessible for everyday investors.
Contract size in practice
This value not only defines the deliverable quantity but is directly related to the dollar value of the transaction. While the deliverable quantity may vary with the underlying asset, there is a standard for each asset type.
The contract size clearly sets out the contractual obligations for both parties engaging in derivatives trading. It also provides consistency among contracts with the same underlying asset. The contract size for all stocks is the same. This means that an investor has no confusion about what they are buying and selling when entering into a contract.
Examples of contract sizes
Contract sizes are standardized and vary by the underlying asset. The contract size for an equity option, for example, is 100 shares of stock. This means that if an investor exercises a call option to buy the stock, they can buy 100 shares per option contract at the strike price.
If the investor exercises a put option to sell the stock, they can sell 100 shares per one options contract.
The trading unit for agricultural futures contracts is typically 5,000 bushels, while the trading unit for livestock futures is 40,000 pounds. The trading unit for weather futures contracts is $20.00 times the cooling degree day index, regardless of the location.
While all contract units are standard for a particular commodity, they may vary within a class of commodities. For example, the contract size for gold is 100 troy ounces, while the contract size for high-grade copper is 25,000 pounds.
Advantages and Disadvantages of Contract Sizes
Standardization of contract sizes can come as an advantage or a disadvantage for investors. Here are some key considerations:
- Consistency – The fact that contracts are standardized to specify the contract size renders the trading process more efficient, and ensures that contracts are consistent for all market participants. All livestock futures, for example, include 40,000 pounds. The unit value of the contract does not change from one trader to another.
- Clearly stated obligations – Standard contract sizes also make it easier for traders to know what they are obliged to do as per the contract requirements. For example, if a farmer sells one livestock contract, it’s accepted that they will be delivering 40,000 pounds. This will be paid in the exact dollar amount specified by the contract size.
- Rigidness – The biggest drawback to standardized contract sizes is that they can’t be modified to better suit individual needs. This means that if a producer needs 7,000 bushels of grain, for example, they either have to purchase one contract, which is typically 5,000 bushels, and be 2,000 short, or purchase two contracts for 10,000 bushels, and have a surplus of 3,000.
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