Contract Unit: What It Means, How It Works, Example

What Is a Contract Unit?

The term “contract unit” refers to the quantity of the underlying asset represented by a single derivatives contract. Depending on the nature of the contract, the underlying asset could be anything that is traded on the derivatives exchange, from agricultural commodities and metals to currencies and interest rates.

Since futures contracts are highly standardized, the contract unit will specify the exact amount and specifications of the asset, such as the number and quality of barrels of oil or the amount of foreign currency. In the case of equity options, for example, every contract corresponds to 100 shares.

How Contract Units Work

Derivative markets have become an increasingly important part of the global economy. Through them, industrial customers can efficiently source large quantities of commodities through a single centralized marketplace.

This has the advantage of decreasing transaction costs, increasing transaction fees, and reducing counterparty risk through clearinghouses and other systems. Financial buyers also actively participate in derivative markets, for purposes such as speculating on commodity prices or engaging in risk hedging activities.

One of the key components of every derivative contract is its contract unit. This critical clause captures the quantity and type of commodity being traded for each derivative contract.

For example, if someone buys one corn futures contract, they are actually buying 5,000 bushels of corn, whereas if someone buys one oil contract, they are buying 1,000 barrels of oil. Gold futures, meanwhile, have a contract unit of 100 troy ounces.

If the unit is too large, many investors and traders who wish to hedge smaller exposures will be unable to use the exchange. Likewise, if the contract unit is too small, trading becomes expensive since there is a cost associated with each contract traded.

To help address this concern, some exchanges have introduced the concept of "mini" contracts to attract and retain smaller investors. By making it easier for these small investors to participate in the derivative markets, exchanges hope to increase the total liquidity of the market, thereby benefiting all investors.

Real-World Example

Different futures contracts can have different contract units even if they are within the same asset category. For example, a CAD/USD futures contract traded on the Chicago Mercantile Exchange (CME) has a contract size of 100,000 CAD, while a Micro E-mini contract also traded on the CME has a size of 10,000 CAD.

Investors need to understand the conventions of the exchange they choose to trade on. Otherwise, they might accidentally expose themselves to a transaction whose value is far greater or lesser than what they had expected. It is imperative that anyone buying or selling futures contracts is aware of these differences and not assume that the unit of the currency will be the same across the board.

Contract Unit vs. Trading Unit

A trading unit, as defined by Nasdaq, is the number of shares of a security that is used as the acceptable quantity for trading on an exchange. Unlike a contract unit, a trading unit does not include a derivative as there is no underlying asset, it is specifically a number of shares that an exchange deems are needed for a security to trade on an exchange, usually in terms of blocks.

A trading unit is typically a requirement set by an exchange to ensure that trading is facilitated efficiently and that there is enough liquidity. Trading units are often in the form of round lots or odd lots.

Round lots are usually 100 shares of stock while odd lots are a number less than 100. Understanding how a specific exchange defines a round lot or odd lot is crucial for an investor to know when making trading decisions.

The Bottom Line

In the derivatives market, a contract unit refers to the quantity of the underlying asset in a derivatives contract. Knowing the contract unit of a derivative is essential as it relays to an investor how much of that asset they are buying or selling. This impacts the performance for speculators as well as price risk mitigation for hedgers.