Here is a topic you’d think most option traders would understand. In all honesty, I am surprised how many do not, at least initially. To me, it can be a scary situation if you don’t know how the option greeks function.

Who’s in Control?

As I like to say in my Group Coaching class or to my one-on-one students, the greeks are like the controls on a car. They give you an idea on how the trade should perform based on how the underlying moves, time passes and volatility changes. But one thing about the greeks that is often overlooked is how they multiply based on contract size. Let’s take a quick look below.

Greeks Multiply

Let’s take a look at an example using the option chain below. Say an option trader buys 1 contract of the March 235 calls because he is bullish on the stock.

The current delta is approximately 0.68, which means for every move of $1 on the stock, the option premium should change by that amount. Gamma would change delta by approximately 0.02 for every $1 change. One day of time passing would currently reduce the call premium by about $0.10 based on the theta, and a 1% change in implied volatility would increase or decrease the option premium by about $0.28 based on the current vega.

But what if 5 contracts were purchased? Now an option trader needs to consider that all the greeks get multiplied by 5 for the overall position. A $1 move higher based on delta alone (keeping gamma constant at this point) would increase the premium by $3.40 (0.68 X 5) or $340 in real money. That is great if the stock rallies, but an option trader needs to understand how the risk multiplies if the stock declines. Losses can grow in a hurry.

Not Just Delta

This will be true across the options chain as well. A day passing now results in the overall premium for the position to drop $0.50 (0.10 X 5). This is true for gamma and vega as well. If an options trader is worried about being exposed in some capacity, he needs to consider position size and/or a spread that may limit his exposure, which he should be doing anyway with this knowledge.

Finally

Knowing what the greeks are and how they can affect your position is paramount for an options trader. Just don’t forget that increasing your position size can affect your profit and loss as well.

John Kmiecik, Market Taker Mentoring