Max Pain Theory or Option Pain

 What is Max Pain Theory?

Max Pain Theory (also called Option Pain) tries to identify the price point around which Option buyers will feel maximum pain i.e. they will incur maximum loss, in contrast option writers will gain maximum profit.

Call option or Put option gives the buyer right but not the obligation to buy (Call) or sell (Put) the stock at the Strike Price by the Expiry Date. In order to get the option, the buyer/owner has to pay Premium to the seller/writer. For option buyer, premium amount is the maximum loss while the profits can be unlimited. However, for option writer the maximum profit is limited to the Premium received while the loss can be unlimited. 

In the market, only small percentage of options are exercised by the option buyers in a given expiry, rest majority of the options die worthless at the end of the expiry. This means that option writers are the ones who are making profit in majority of the cases. Moreover, option writers are usually big players, with lots of resources including money and analysts, who are capable of driving the prices. With all these consideration, the Max Pain theory suggests that there should be a price point were the option writers (both call and put) will feel least pain or will incur least loss. In the contrary, the option buyers will feel maximum pain. According to this theory, by the end of the expiry, the price of the stock will move around this range, as the options will become worthless and maximum option buyers will loose the premium amount.

How to calculate the Max Pain option price?

Max Pain is the sum of the outstanding put and call Rupee value of each in-the-money strike price.

For each In-the-Money strike price for both Call and Put options:

1. Find the difference between stock current market price (close price) and strike price
2. Multiply the result (price difference) by open interest at that strike
3. Add together the Rupee value for the put and call at that strike
4. Repeat for each strike price

Calculating Max Pain though simple but is time consuming, as this needs to be computed at least on a daily basis, for each of the stocks/indexes one wants to trade in.

StoxFactor computes the Max Pain prices for all the future and options stocks and Nifty and BankNifty on a daily basis and displays them in the dashboard.

However, it is sometimes important to note when there is a large difference between the current stock price and the max pain price. There could be a tendency for the stock to move closer to max pain, but the effects may not be meaningful until expiration approaches.

This theory has its own set of criticism like whether this is a case of price movement or price manipulation. Leaving aside the controversy, one should remember which side wins majority of the time. Since both sellers and buyers cannot win and its the option writers who win the bets majorly, one should try to read the option chain data and estimate the price movement with the perspective of the option writers.

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