If you have been in the stock market for a while, you must have heard of many theories like option greeks, implied volatility fluctuation, and of course max pain theory to name a few. Most of the theories in the market are new as the concept of options itself is very new in comparison to the history of the stock market itself.
These different theories demand multiple data points for analysis and the traders require a suitable set-up with a predefined risk appetite to be able to make the most out of these theories in practicality. Some theories work for a few while others work for a different set of traders. Having that said, let us know about max pain theory in detail in this article and then you can decide whether this suits your style of trading or not.
So let’s begin!
What is Maximum Pain Theory?
- Max pain is the financial situation that is looked at from the perspective of option sellers or option writers. It is determined based on the volume of open interest at different strike prices of live option contracts.
- As per this theory, there is one strike price, which is called, max pain price, at which the maximum number of call and put writers have built up their positions. They will have maximum pain of loss if the stock expires away from that strike price.
- Therefore, this theory suggests that the price of the stock will ultimately move towards the price at which maximum pain for sellers is present and one can use this to create buying and selling strategies.
Decoding Max Pain
The concept of the max pain theory is that if the underlying asset’s price stays locked in with the strike price, options traders, especially the call and put sellers, can lose big money. Max pain is the price at which the most open options contracts are standing. It is called open interest. It is the price that would cause the most number of option holders to lose money at expiration.
The concept of max pain refers to the idea that most traders who bought and are holding options contracts until their expiration might lose money. And since more than 80% chances are that the option sellers will make money, the max pain theory gets some validity.
How does Max Pain Theory Work?
- The maximum pain theory explains that when the price of an underlying stock rises, it tends to reflect the number of worthless options.
- As the options expiration approaches, call and put writers will attempt to drive the price of their shares higher to capture more of their payouts.
- The maximum pain theory states that option writers will hedge their contracts to avoid making a loss.
- About 60% of options are traded out, and 30% of them are worthless. The remaining 10% are exercised.
- The maximum pain theory is a controversial topic. Critics believe that it is a result of market manipulation or a matter of chance.
How to determine the Point of Maximum Pain?
Max pain point takes a lot of time for calculation yet it is a simple process to calculate the same. It is computed by aggregating the value of the put and call options outstanding for all the strike prices.
It is the addition of open interest outstanding on the call and put side of the option chain data found on the website of the National Stock Exchange. It can be computed in the same way for both stocks and indexes.
Following are the steps involved in the computation of max pain points.
- Step 1: Ascertain the difference between the current market price of the stock and the strike price.
- Step 2: Find the open interest at that strike price and multiply it with the result from Step 1.
- Step 3: Perform this computation for both, call and put options.
- Step 4: Take the sum of values derived from the call and put open interests.
- Step 5: Carry out the same drill for all the available strike prices.
- Step 6: Ascertain which strike price has the highest value.
That strike price is the point where the options traders will have the maximum pain of bearing the monetary loss.
Complications in determining Max Pain
The max pain price can change in real-time, and it can also be a bit challenging to use as a trading tool. However, it’s sometimes valuable to note that the current stock price and the maximum pain price are both significantly different.
Another problem could be that after taking so much effort you calculate the point of max pain but when the stock price goes to that point, there will not be the impact you are looking for since the expiry is far. This strategy would be helpful only when the expiry is closer.
Understanding it with an Example
Let us assume that there is a stock ABC that is currently trading at Rs. 145. And as per the max pain theory, the highest aggregate open interest of call and put options is at the strike prices of Rs. 150 and Rs. 152.50.
So as per the Maximum Pain Theory, the stock price on the date of expiry is likely to end closer to either of these strike prices otherwise there would be a maximum loss to options traders if the price closes significantly away from the max pain.
The concept of the max pain point hasn’t been around for a very long time. It is considered a relatively newer concept if other theories and strategies are to be compared. The usage of this theory is more popular amongst traders especially those who write options and investors who hedge their cash market positions using derivatives.