Futures and Options are two important standardised derivative contracts. It is standardised based on the quantity, price, and expiration date. Therefore, quantity based on the lot size is a vital aspect that helps you engage and settle a futures or options contract.
Published on 17 March 2023
Therefore, let us understand the basics to ensure you capture the good trading practises and choices to earn maximum profits.
A lot size in the futures and options refers to the minimum size of the underlying asset that you can trade in the derivative market. Therefore, while you trade on futures or options, you will buy or sell the products based on the minimum lot size or multiples of the defined lot size. For instance, Reliance Industries Limited has a lot size defined as 250. Therefore, you can only trade the RIL futures and options as a multiple of 250.
Futures and Options contracts are standardised in the derivative market. It is unlike the forward contract that happens Over-the-Counter. And one of the most important ways to standardise a contract is by defining the lot sizes.
To understand it better, let us consider a seller who wants to sell a specific quantity of shares which is slightly odd in number. There is an issue when there are no buyers for the quantity of mentioned shares. The stock exchange can handle such issues by standardising the purchase and sales of shares based on a minimum lot size or multiples of the lot size.
To understand lot size and how it is fixed, you must know that the futures and options contract is standardised based on size by fixing the notional value, the product of size, and the price. Therefore, the notional value is different from the actual payable margins. It is a fraction of this calculated notional value.
Initially, SEBI had fixed ₹2 lakh as an indicative lot size. Then, the lot size of the individual stocks or indices would be fixed based on the relevant number of shares, which gives a notional value of above ₹2 lakhs when multiplied by the current market price. It was the procedure to fix the lot size until 2015.
In 2015, SEBI decided to check speculation further as the retail investors were not conclusive about the risk involved in the futures and options trading. Therefore, the SEBI increased the indicative lot sizes to above ₹5 lakhs to discourage participation.
The Futures and Options list is getting modified with the inclusions in the range of notional value between ₹7.5 lakhs and ₹10 lakhs. If there is a sharp divergence of the lot value from this range, then SEBI will further review and modify the lot size.
The lot sizes are decided based on the indicative lot size defined by the SEBI. However, the indicative lot size can change when there is a sharp increase or decrease in the stock price. For instance, a stock with a defined lot size of 1000 and ₹700 will have a notional value of ₹7 lakhs. If the stock price increases from ₹700 to ₹1400, the notional value will change to ₹14 lakhs. Such an increase will make it difficult for the traders to invest and pay the margins, affecting liquidity.
In the case of stock price correlations, the reverse logic applies. SEBI will increase the lot size to make it more compatible based on the indicative lot value. As the indicative lot sizes are fixed, the individual lot sizes have to be modified and reviewed based on the market price fluctuations of the particular stock or index. Therefore, it is reviewed and fixed on a routine basis.
The lot size of a stock with a higher price will have a smaller lot size, and stock with a lesser price will have a larger lot size. And, the notional value of both the types of stock will be closer in range, and that becomes the standard for trading in Futures and Options.
Lot size defines the minimum quantity for purchasing futures and options contracts. A trader can purchase the quantity of the specified stock futures based on the lot size or the multiples of the lot size. It is introduced to standardise the basis of the futures and options contract.
SEBI regulates, reviews, and modifies the lot sizes based on the price movements. It is done predominantly to discourage traders with limited understanding who get involved and make losses in the derivative market. Hence, educate yourself on the concepts or get assistance from brokers to earn profits in the futures and options contract!