The max pain of an options trade is the strike price with the most options contracts. It’s the price that causes financial losses for the greatest number of options holders at expiration.
Learn more about this important options trading concept today.
Max Pain Defined
Max pain, or the maximum pain price, is the strike price with the most open options contracts combining puts and calls. It is the strike price that causes the highest dollar value of losses among option buyers on a given stock at a specific expiration.
According to the Chicago Board Options Exchange (CBOE), about 30% of options expire worthless, 10% are exercised, and 60% close out before expiration. The concept of max pain focuses on the 30% of options that expire with no intrinsic value.
Some large institutional options sellers see an investment opportunity in writing options that eventually expire worthless, according to max pain theory. If options expire worthless, the seller of those options keeps the entire premium as profit.
Max pain options trading stems from the Maximum Pain Theory. The theory contends that option sellers seek to hedge portfolios with options expiration. The Maximum Pain Theory also suggests an option’s price will arrive at a max pain price where the most options contracts held through expiration will experience losses. Bear in mind that an options contract that is not “in the money” at expiration is worthless.
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How Max Pain Works
The Maximum Pain Theory asserts that the price of the underlying asset is likely to converge at the maximum pain strike price. The max pain price is the strike with the greatest dollar value of calls and puts. As the expiration date approaches, the underlying stock price might “pin” to that option strike price.
Some day traders closely monitor the max pain price on the afternoon of expiration – usually the third Friday of the month for monthly options or each Friday for weekly options contracts.
Max Pain trading can be controversial, as some believe it borders on “market manipulation” when traders seek to pin a stock price to a certain price at a certain time. Market participants disagree about whether or not Max Pain Theory works in practice. If a trader can predict which strike price will feature the greatest combination of dollar value between calls and puts, the theory states that they could profit from using that information.
Some market makers may consider Max Pain Price Theory when hedging their portfolios. Delta hedging is a strategy used by options traders – often market makers — to reduce the directional risk of price movements in the security underlying the options contracts. A market maker is often the seller of options contracts, and they seek to hedge the risk of options price movements by buying or selling underlying shares of stock.
This activity can cause the stock price to converge at the max pain price. Delta hedging plays a significant role in max pain trading.
How to Calculate the Max Point
Calculating the max pain options price is relatively straightforward if you have the data. Follow these steps to determine the max pain strike:
• Step 1: Calculate the difference between each strike price and the underlying stock price.
• Step 2: Multiply the results from Step One by the open interest at each strike.
• Step 3: Add the dollar value for both the put and the call at each strike.
• Step 4: Repeat Steps One through Three for each strike price on the option chain.
• Step 5: The strike price with the highest dollar value of puts and calls is the max pain price.
Since the stock price constantly changes and open interest in the options market rises and falls, the max pain price can change daily. An options trader might be interested to see if there is a high amount of open interest at a specific price as that price could be where the underlying share price gravitates toward at expiration, at least according to Max Pain Theory.
Max Pain Point Example
Let’s assume that XYZ stock trades at $96 a week before options expiration. A trader researches the option chain on XYZ stock and notices a high amount of open interest at the $100 strike. The trader performs the steps mentioned earlier to calculate the max pain price.
Indeed, $100 is the max pain price. Since the trader believes in Max Pain Theory, they go long shares of XYZ on the assumption that it will rise to $100 by the next week’s options expiration. Another options trading strategy could be to put on a bullish options position instead of buying shares of the underlying stock.
This hypothetical example looks simple on paper but many factors influence the price of a stock. There could be company-specific news issued during the final days before expiration that sends a stock price significantly higher or lower.
Macro factors and overall market momentum might overwhelm market makers’ attempt to pin a stock to a max pain strike. Finally, stock price volatility could cause the max pain price to shift in the hours and even minutes leading up to expiration.
Pros and Cons of Using Max Pain Theory When Trading
Max Pain Options Theory can be an effective strategy for options traders looking for a systematic approach for their options strategy. That said, not everyone agrees that Max Pain Theory works in practice. Here are some of the pros and cons of Max Pain Theory.
|A systematic approach to trading options||Lack of agreement supporting the theory|
|Trades the most liquid areas of the options market||Stock prices don’t always gravitate to a max pain price|
|Benefits from supposed market manipulation||Other factors, such as market momentum or company news, could move the stock price|
Max pain trading in the options market is easier today amid a brokerage world with low or even no commissions. Previously, it was simply not economical for many retail traders with small account sizes to buy and sell options using max pain theory.
Critics contend that there should be more regulatory oversight on max pain price trading — particularly on large institutions that could be manipulating prices. It’s unclear whether there will be more oversight of such practices in the future.
Max Pain Theory is one approach to options trading based on the strike price that would cause the most losses. Options traders who calculate the max pain price, can use that information to inform their investing strategy. But it’s not necessary to invest in options at all to build your nest egg.
But if you’re ready to tackle options trading, check out the SoFi options trading platform. Investors can trade options either from the mobile app or web platform, with an intuitive and approachable design. Whether you’re a seasoned trader or an options trading beginner, you might also perusing the educational content about options offered, too.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.