Valuing a Contract and the Capital Required to Trade It - Part 1

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Valuing a Contract and the Capital Required to Trade It - Part 1

When we speak of a Futures Contract, we are referring to a standardized contract being created between two parties to either buy or sell a specific asset (Corn, Live Cattle, Oil, etc) having standardized quantity and a graded quality at a specified future date at the price agreed upon today. This is where the word Futures comes from. The Futures Exchanges provide a central location for these parties to come together and create these Futures Contracts. These contracts are not like Stocks or Bonds where you directly own them. Futures contracts are a type of a derivative. Think of a derivative as a financial instrument for two parties to make an agreement about the expected future price movement of the underlying assets. These underlying assets could be the actual (Cash) Commodities themselves (ie, Live Cattle, Oil, Gold, etc.) or shares of stocks that are in an Index (ie, S&P, Nasdaq, Dow, etc.). Once you enter these Futures Contracts, you have two ways of fulfilling your contractual obligation:

1. Offset your position in the Futures market. If you originally bought the contract, you would then sell the contract. If you originally sold the contract, you would then buy the contract. 98% of all Futures Contracts are fulfilled this way.
2. Take delivery of the underlying asset or deliver the underlying asset at the expiration of the Futures Contract. Only 2% of Futures Contracts are fulfilled this way.

Now we need to determine how much these contracts are actually worth while we hold these Futures positions. Many of you already invest in Stocks and understand the valuing of the transaction. If you buy 100 shares of a $10 Stock, you will have to pay either $1,000 (full cash value) or use your margin account and pay $500 plus any interest accrued during the time you hold the position.

In Futures, we value the contract differently by using one of these:

• Contract Size ñ Commodity Markets use this
• Multiplier ñ Stock Indexes use this

Since the majority of all Commodities are priced in United States Dollars we must next look to see what the pricing units are. These units could be per pound, barrel, bushel, etc. The Contract specifications will tell you exactly how many cents or dollars per unit there are to each individual Futures Contract. You can find the current specifications for 85% of the world Commodities on the Chicago Mercantile Group (CME Group) website. Click here to view the contract specifications for the Live Cattle market.

Table 2 will show us the pricing units for some Commodities along with the last price traded on your screen. The last price in terms of per unit value will give us the dollar value of the Commodity.



Now that we know how to find the Commodity value, we must decide how much the actual Contract Value is in dollars. To do this, we will take the Commodity Value and multiply it by the Commodity Contract Size. Table 3 will show some examples of this equation.






Now that we know the Multiplier values, we can determine what the Contract Value in dollars will be. Table 5 will show that multiplying the last price on your screen by the Multiplier will give you the Contract Value in dollars.



Understanding the total value of a contract can give a trader a better perspective of just how much money they are dealing with. Next week I will discuss the amount of money you need to trade these contracts, Margin (a.k.a. Performance Bond). Considering you only need to have 8-10% of the total Contract Value in Dollars, it is very easy to get over leveraged. Trading just 5 E-mini S&P contracts ($309,000), you are approaching the value of a single family home in many regions.

Always use good risk management when trading these highly leveraged instruments. Just as quickly as you can have a windfall profit, the market can also cause you to lose a large sum of capital.

"Our plans miscarry because they have no aim. When you don't know what harbor you're aiming for, no wind is the right wind." Seneca

- Don Dawson
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