Max Pain
Candlefocus EditorThe max pain theory is a popular trading concept that states that the price of an optionable stock "gravitates" towards a price which causes the maximum number of options to expire worthless. This price is also known as the 'maximum pain' or 'max pain' price. By understanding this theory and identifying the current max pain price of a stock, investors may be able to gain an edge in the options market.
The standard logic behind the max pain theory is that the stock's price will stay within the strike prices at which the least number of option contracts have to be exercised in order to fulfil their obligations. In other words, the stock's price will move towards the vicinity of that strike price which would cause the maximum number of option contracts to expire worthless.
What Causes That Price Point?
The idea is that market participants want to avoid exercising their option contracts if the option has negative value (when the stock is trading below the strike price for a call option and above the strike price for a put option). This means that the option holders will be trying to gain the maximum profit from their positions, by keeping the stock price away from the strike price of their option contracts.
This collective pressure from all the option holders to move the price away from specific strike prices causes the price of a stock to gravitate towards the point where option contracts of maximum people would expire worthless.
How To Calculate Max Pain?
It is possible to calculated the max pain price of an optionable stock. This is done by analysing the current open interest and contract values of the stock's related options.
The trader first has to compute the total options value of all the in-the-money call and put options. The total options values should be calculated separately by taking into consideration the open interest, option’s strike price, and the underlying stock’s price at that point in time.
Once the total options value of all the in-the-money call and put options is known, the max pain price for the stock can be calculated as the average between the maximum value of the in-the-money calls and minimum value of the in-the-money puts.
Final Thoughts
Max pain theory is an interesting concept and one that can be used by option traders to potentially gain an edge over the market. By tracking and calculating the max pain price of a stock, traders can gain an insight into which direction the stock’s price will move in, and take their positions accordingly.