If you’ve been trading stocks for any length of time, you’re probably familiar with concepts like the option greeks, implied volatility fluctuations, and the Max Pain theories. Given that the concept of options has only been around for a very short time in comparison to the stock market’s history, most market theories are also relatively recent developments.
To make the most of these theories, traders need a good setup and a clear idea of how much risk they are willing to take. Each of these theories also requires traders to look at multiple data points. Many groups of traders find success with various theories.
In this article, you will learn about one such theory in options trading called Max Pain.
Let’s get started!
Max Pain: What Is It?
The price at which the underlying stock typically settles is known as the “maximum pain strike price.” It is the point in time when most options (measured in dollar terms) will expire worthless.
We evaluate max pain by using the open interest volume in active options contracts with different strike prices. According to this theory, a single strike price is the “max pain price,” where the most significant combined positions of call and put writers exist.
This theory can help you decide how to buy and sell stocks because it says that the price of a stock will eventually move toward the price at which sellers feel the most pain.
Max Pain’s Explanation
The maximum pain theory says that option writers should protect themselves by hedging their positions, just like market makers do to keep the market neutral. Imagine the market maker’s predicament if he or she has to set up an option contract but doesn’t want to buy or sell the underlying stock.
The option writers will attempt to buy or sell stock as the options’ expiration date approaches to influence the market toward a favorable closing price or to ensure they receive payment from option holders. Writers of call options expect the share price to go down, while writers of put options expect the price to go up. Sixty percent are sold, thirty percent expire without being exercised, and ten percent are taken up on their offer.
Max pain is when option buyers and owners experience the greatest potential loss. Yet option sellers may benefit the most from this situation.
There is debate regarding the “max pain” idea.
When the underlying stock price tends to move closer to the maximum pain price, there is debate among the theory’s proponents and detractors as to whether this is an instance of market manipulation or just random chance.
How to Calculate the Max Pain Point
The computation for maximum pain is straightforward but laborious. It displays the aggregate value of all active call and put options with an in-the-money strike price.
Every time a put or call has an in-the-money strike price:
Step 1: Determine the difference, i.e., minus the stock and strike prices.
Step 2: Find open interest at that strike and multiply by the outcome.
Step 3: Sum the call and put prices at that strike.
Step 4: Must be done again for each strike price
Step 5: Determine the best possible strike price.
Step 6: This is the Max Pain price.
Using Max Pain as a trading tool is challenging since it may change every day, if not every hour. Yet, it’s worthwhile to notice when the present stock price is far lower than the max-pain price. The stock price could be drawn toward the maximum pain level, but the impacts might only become significant once the option’s expiry date draws near.
Real World Illustrations
Suppose Company XYZ Limited is interested in trading stock options at a time when the stock’s options have a $51 strike price. The stock options with strikes between $54 and $55 see heavy trading volume under these conditions. The maximum pain price will ultimately be reached because both costs will make the company’s stock options that have the highest value expire worthless.
In another example, let’s say that Company X has many options trading on its shares, most of which are at a strike price of $50. Let’s pretend the stock price of the firm was $50 at the time the option expired. Any option with a $50 strike price is in the money and will thus expire worthless.
The goal of options trading is to earn a profit by anticipating when the maximum price of an asset will be on the day of expiry. This strategy is optimal when market circumstances are typical.
Let’s pretend that stock ABC is trading at $145 right now. According to the max-pain theory, options with a strike price of $150 or $152.50 have the largest combined open interest of put and call options.
Options traders stand to lose the most if the stock price on expiration day differs considerably from the two strike prices.
According to the maximum pain principle, sellers of calls and puts stand to lose the most money if the underlying asset’s price remains at the strike price. Maximum anguish occurs when open option contracts reach this level. “Open interest” is the term for it. It’s the price at which the largest proportion of option holders would be negatively affected.
The term “max pain” describes the potential for financial loss for most traders who have purchased and are now holding options contracts till expiry. Since option sellers can expect a return of more than 80%, there is some support for the “max pain” theory.
Difficulties in Establishing a Max Pain Value
The maximum pain price is dynamic and challenging to apply in financial transactions. There may be significant differences between the current stock price and the max-pain price, so it is vital to keep this in mind.
Another area for improvement is that even if you invest the time and effort to determine your maximum point of pain, the expiration date may be too far in the future for the stock price to have the desired effect. This tactic would be helpful only if time were getting close to its expiration.
You can’t escape the inherent risk and volatility in the financial system. Yet, this in no way diminishes the lucrative potential of these financial tools. Buying financial products like stocks, currencies, and derivatives is one of the investor’s most potent tools. But there is always something lacking while reading financial blogs that promote financial literacy: the possibility of losses. While many shareholders aim for gains, losses are always a possibility.
Every investor would do well to educate themselves on the causes that may lead to losses and those that can lead to gains, since losses are just as likely for a novice investor in securities as gains.
The max pain idea was first proposed in 2004, so it is still too young to have undergone exhaustive testing. While many investors have found success with the max-pain strategy, there still needs to be more in-depth written material on the topic.
Assuming that 90% of options contracts are worthless when they expire, the max pain theory predicts that there is a specific point at which the options buyers would suffer the most and the options writers would suffer the least.
How reliable is the max pain theory?
The maximum suffering hypothesis has been correct for investors on occasion. The Max Pain Theory is helpful, but only when combined with other fundamental and technical signs.
What does “max pain” mean in cryptocurrency?
The largest loss that an investor in options with a cryptocurrency as the underlying asset might incur is known as the “Max Pain” in crypto.
How can “Max Pain Theory” help a trader?
Traders can profit from this idea. Based on this theory, writing an option right before it expires makes sense as long as other technical signs support it. No deal should be made without carefully considering the technical or fundamental aspects.
What is a strike price?
The original purchase price of the options contract or the set price
Can you explain the in-the-money (ITM) option?
In this case, the underlying asset’s price is greater than the option’s strike price.
What is a spot price?
Spot price refers to the current market value of the asset underlying the options contract.
What is an option?
A contract known as an option grants the buyer the right, without the obligation, to sell an asset at a specified price on or before the option’s expiration date. Investors can use online trading options to buy and sell stocks, ETFs, and other securities at a set price and within a set amount of time.
What are call options?
The right, but not the obligation, to buy the underlying asset on or before a specific date and for a predetermined price is granted to the call option holder.
When do you use a put option?
The opposite of a call option is a put option. In contrast to a call option, which grants the holder the right to buy the stock, a put option grants the holder the right to sell shares on the specified date.