Using Contract Size to Maximise Returns
In the domain of share trading, 'contract size' refers to the standardised unit of trading in specific financial instruments (futures, stocks and options). This blog explains how investors can choose the right contract size that aligns with their trading strategy.
Introduction to contract size
In the domain of share trading, 'contract size' usually means the standardised unit of trading for a specific financial instrument. These include futures, stocks and options. It specifically states the amount or quantity of the underlying asset which is being purchased or sold during a single transaction. The type of financial instrument determines the contract size.
- Stocks: While trading in stocks, there is usually no standardised or specific contract size. Traders can purchase or sell as many shares as they want, just as long as there are enough willing buyers or sellers at the other of the transaction in the market. Hence, for stocks, the contract size can be flexible and may be as small as one share.
- Futures contracts: In the context of futures trading, the size of the contract depends on the exchange on which the futures contracts are being traded. Futures contracts usually refer to standardised agreements to purchase or sell a specific quantity of an underlying asset at a fixed price and at a date in the future. For futures contracts, the contract size changes based on the asset that is being traded.
- Options contracts: For options, contract sizes are standardised. An options contract grants the holder of the contract the right (without an obligation) to purchase (call option) or sell (put option) a fixed number of shares of an underlying stock. Usually, options' contract size is 100 shares. However, this can vary in some cases.
How investors decide on contract size:
Traders decide on contract size based on factors such as risk tolerance, trading goals, availability of capital and the financial instrument that they are trading in. The following are a few of the key considerations used for deciding on the appropriate contract size:
- Risk tolerance: Traders usually determine their tolerance for risk, which is their ability and willingness to absorb potential losses. A contract size that is larger can potentially provide larger profits, but the risks are higher. Depending on the risk tolerance, an appropriate contract size is determined.
- Capital availability: The availability of sufficient capital determines the contract size that an investor opts for. More capital is needed for trading larger contract sizes. It's imperative not to over-leverage an account because of the risks of losses.
- Trading strategy: An investor’s trading strategy helps to determine the appropriate contract size. Contract sizes typically differ based on the investment strategy. A day trader will usually opt for contract sizes that are small in order to manage risk. Meanwhile, an investor with a long-term strategy will choose larger contract sizes to buy and hold them.
- Volatility of the instrument: The historical volatility of a financial instrument will influence investors to opt for smaller contract sizes to reduce risks. For less volatile assets, larger contract sizes are the better choice.
- Trading costs: Transaction costs such as fees and commissions eat into profits. Usually, smaller contract sizes are deemed to be cost-effective for minimising these expenses.
- Regulatory requirements: Regulatory authorities usually set minimum contract sizes and specific trading requirements for certain instruments. Irrespective of the risk tolerance and availability of capital, investors have to ensure that they are complying with these regulations.
- Portfolio diversification: Investors who trade in several financial instruments analyse how each trade's contract size fits into the portfolio diversification strategy. Diversifying the trades to spread risk is a strategy that is used by most investors and contract size in this regard is a crucial consideration.
- Skill and experience: The level of expertise and experience in trading influences the choice of contract size. Traders who are just starting out are usually more careful and start with small contract sizes so that they can gain confidence and experience. They can level up as they progress and become more aware of how the market works.
The correct contract size should be decided upon after carefully taking into account all these factors. Often, a good approach to starting off is opting for smaller contract sizes. This is especially important when the investor is new to the world of trading. A gradual adjustment of the contract size with more confidence and experience will help minimise risk.
Apart from that, investors, both new and old, seek help from mentors and financial professionals when trying to determine the correct contract size for their specific circumstances. Apart from contract size, there are other market factors and dynamics that they need to deal with. For this, help from skilled traders proves to be a handy tool.
Also, there are no fixed rules for determining the appropriate contract size. It is unique to each investor and should eventually align with the individual's risk tolerance, financial situation and trading objectives. To ensure that the contract size is best suited to the goals, prioritising risk management and not over-leveraging the trading account can prove to be the most helpful.