Why Different Derivative Contracts Have Different Lot Size | Espresso

Why Different Derivative Contracts Have Different Lot Sizes?

To truly decode Future and Options trading, it is important to understand the notion behind lot size. The idea behind lot sizes is related to standardisation. The main difference between forwards and futures is that forwards have not been standardised, whereas futures are standardised.

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Because futures are standardised, there is a prepared secondary market. So, what types of derivative contracts are available, and why do they have different lot sizes? 

Well, don't panic. We got you covered. But, before moving forward, let us give you a basic understanding of what derivatives are.

What are Derivatives? What are the Kinds of Derivative Contracts?

A derivative is a financial contract whose value depends on a group of assets or underlying assets. Commonly used assets are bonds, commodities, stocks, market indices, and currencies. The underlying asset's value is constantly changing based on the market conditions. The basic concept of a derivatives contract is to make a profit by guessing the worth of the underlying asset in the future.

Visualise that the market price of a stock can go up or down. A decline in the value of a stock may result in a loss. You can enter into a derivatives contract for a profit by placing a real bet in this situation. Or protect yourself from losses in the spot market where stocks are traded.

Derivative Contract Examples

  • Options: An option is a derivatives contract that gives the buyer the right to buy or sell an underlying asset at a specific price within a specific period. The buyer does not need to exercise the option. Instead, the seller of the option is called the option seller.
  • Futures: Futures are standardised contracts that allow holders to buy or sell an asset at an agreed-upon price on a particular date. The parties to a futures contract are obligated to perform the contract.

These contracts are generally traded on the stock exchange. Futures contracts are valued in the market every day. This means that the value of the contract will adjust according to market movements until its expiry date.

  • Forwards: A forward is analogous to a futures contract in which the holder is obligated to perform the contract. However, forwards are not standardised and are not traded on exchanges. They are available without a prescription and are unbranded. It can be changed according to the requirements of the contracting parties.
  • Swaps: A swap is a derivatives contract in which two parties exchange financial obligations. Cash flow is hinged on a notional principal agreed by both parties without principal exchange. Cash flow amounts are based on interest rates.

One cash flow is usually fixed, and the other depends on the underlying interest rate. The most commonly used is the interest rate swaps. Swaps aren't traded on stock exchanges. They are over-the-counter contracts between financial institutions and businesses.

How Lot Sizes are Fixed?

SEBI (Securities and Exchange Board of India) had set ₹2 lakh as a benchmark initially. The lot size was set at the equivalent number of shares would give a face value of over ₹2 lakh when you multiply them by the current market price. However, in 2015, SEBI changed the indicative lot size to over ₹5 lakh to deter retail investors from speculating in futures and options.

As a matter of fact, the new inclusions being incorporated into the futures and options list have a minimum lot value of ₹7.50 lakh. Also, there is a chance to alter the lot value to a figure of ₹10 lakh to help only informed traders and investors when it comes to trading in the Futures and Options market.

When ₹2 lakh was the value for the Nifty lot, the initial margin that was needed was only around ₹25,000 that was needed for one lot of Nifty, making it within reach of most small investors. In most of the cases, they didn't understand the real impact of futures and options and, in the end, suffered huge losses.

Why Does the Lot Size Change Normally?

The lot size is linked to display lot values, but these lot values change with the price. For instance, if a stock that has a lot size of 1,000 shares is priced at ₹210, the lot will be worth ₹2.1 million.

However, if the stock price rises to ₹550 in the following year, the lot value will automatically change to ₹5.5 million. In such cases, the Securities and Exchange Board of India (SEBI) may attempt to change the lot size to 500 shares to ensure that ₹2.75 lakh lot value more accurately reflects the expected lot value.

Conclusion

Therefore, if the stock price is revised, the reverse logic is applied. In such cases, the Securities and Exchange Board of India will revise the lot size to better match the expected lot value. These lot size changes are made regularly as stock prices move. The bottom line is that individual lot sizes should be fixed relative to the market price of an index or stock since the indicated lot values ​​are fixed. So, the lot sizes are different.

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Frequently Asked Questions

Derivative contracts are basically securities based on the underlying asset's price, like bonds, stocks, currencies, commodities, etc. The underlying asset amount represented in the derivatives contract is the contract size.

Every type of person has an objective of participating in the derivatives market:

  • Hedgers
  • Speculators
  • Margin traders
  • Arbitrageurs

  • One must understand how derivatives markets work prior to trading. The strategies applicable to derivatives are overall different from those used in the share market.
  • The derivatives market requires one to deposit a margin amount before they begin trading. The amount of margin can't be withdrawn until the particular trade is settled. In addition, one has to replenish the total amount when it falls below the minimum level.
  • One needs to have an active trading account that allows derivative trading. If they use the services of an online stockbroker, they can place orders online.
  • When choosing stocks, one needs to consider factors such as margin requirements, cash in hand, the contract rate, and that of the underlying stocks. They need to make sure that everything is within their budget.