Team Espresso
We care that you succeed
Bringing readers the latest happenings from the world of Trading and Investments specifically and Finance in general.
Option Pain: Here's All You Need to Know
Max Pain is a situation where the stock price locks on a strike price as it moves forward towards its expiration. This can lead to monetary losses for the highest possible of traders. Max Pain aims to define how, in the last days, the underlying stock prices sometimes cluster around the strike price, which can provide all the option buyers with losses. Let’s learn more about Max Pain from this article in detail.
Published on 06 February 2023
However, whenever you will be reading a finance blog that inspires your financial knowledge, there is always one thing missing - loss potential. Nonetheless, most investors want to make a profit and there is always the possibility of a loss.
Losses are as common as gains for investors who do not fully understand securities investing. It is important for any investor to learn about the loss factors as much as the gains. In the endless list of controversial market theories, the "option pain" theory certainly finds its place. ‘Option Pain’ or ‘Max Pain’ has a lot of fans, and those who despise it are probably pretty much the same in number.
What is Max Pain in Options?
Max Pain is a financial position determined by the strike price of most options contracts. The maximum pain price is the rate at which the share will cause the greatest financial loss to all option holders that have entered into a contract at that strike rate at expiration.
The position is determined by the price of the stock (the underlying asset), which fixes the strike rate of the options contract as the date of expiration approaches. The maximum pain theory attempts to define how options traders can suffer significant losses if the spot price of the underlying asset matches the strike price of the contract.
Decoding the Max Pain
When it comes to the concept of max pain, the price of the underlying assets stays locked along with the strike price. The put-and-call sellers and the options traders might lose their funds.
Max Pain is also known as the price on which all the open option contracts are currently standing. This is called open interest. The price is what will make the majority of the option holders lose their funds during expiration.
The concept of max pain is pointed towards the idea that many traders who purchased and are also holding the options contracts till the expiration will lose funds. Experts say there is over 80% chance that the option sellers will profit. In return, it will ensure that the max pain theory obtains validity.
Calculating Max Pain Point
Max Pain or Option Pain is a time-consuming but simple calculation. Typically, this is the sum of the outstanding call amount and the put rupee at each in-the-money strike. The max pain point can be calculated as follows:
- Spot the difference between the price of the underlying asset and the strike price of the contract.
- The difference is multiplied by the open interest at the specified strike price.
- Add the value of call and put options in rupees at the specified strike price.
- Repeat the above-mentioned process for each contract strike.
- After repeating this process for each strike price, the maximum value of the strike price is the max pain point.
How Exactly Does Max Pain Work?
Once you know ‘what is option pain’, you will also know how exactly it works. Experts say that the max pain theory describes that when the underlying stock price increases, it reflects many worthless options.
When the option’s expiration time gets closer, the put and call writers will drive the share prices higher. It will help you get much more payouts. The max pain also mentions that all the option writers hedge their respective contractors, which prevents them from making any losses.
According to experts, about 60% of the options get traded, and 30% do not. But the remaining 10% of the options get exercised. But this particular theory can be a controversial topic. People believe that it’s the outcome of a matter of chance or market manipulation.
Determining the Point of Maximum Pain: How to Do it?
When calculating the maximum option pain point, it can take a good amount, even though it’s pretty easy to calculate. It’s computed through the aggregating value of the call and puts options that is outstanding for the strike prices.
It’s also known as the addition of the open interest outstanding on the put and call site of the data, which is found on the National Stock Exchange’s website. It gets computed in the same way for both the indexes and stocks. To learn how to calculate the maximum option pain, here are the steps to follow:
Step 1 – Take a look at the difference between the strike price and the existing stock market price.
Step 2 – Look for the open interest on that strike price, and after that, multiply it with the outcome from Step 1
Step 3 – Conduct this particular computation for both the put and call options.
Step 4 – Take the sum of the values from the put and call open interest.
Step 5 – Conduct the same drill for all the available strike prices.
Step 6 – Check which strike price has a much higher value.
Max Pain: Taking a Look at the Example
When you wish to know what is max pain in options is, here is an example that will help you greatly:
“Let’s say the options of the stock ABC are trading at a strike price of $48. But there is open interest on ABC options with strike prices of $51 and $52, respectively. So, the maximum pain price will help settle one of the two values. It’s mainly because they will push the maximum number of the ABCs option to expire worthlessly.”
How Can One Trade Using Max Pain Point?
As an option contract approaches expiration, traders sell or buy an underlying asset, like a stock, raising the price to a closing price that is beneficial to them. In addition, they also try to guard their positions on payouts to option holders. For instance, a call option writer might want the stock price to fall, and a put option writer might want the stock price to go up.
Also Read: What is Call Writing?
According to the max pain theory, the expiration price always moves to the price at which the investor loses the most. Bearing this into account, a trader can sell or buy a contract for a profit if the maximum pain point is significantly above or below the latest market price of the stock.
For instance, if the spot price of Bank Nifty is ₹25,800, the spot price of the contract is ₹25,600 and the maximum issue is ₹25,000, the trader may consider selling Bank Nifty options accordingly.
Additionally, traders can use the max pain point to fence losses on option positions or profit before taking huge losses. For instance, if you have a Bank Nifty call option with a strike rate of ₹26,700, the latest spot price of ₹27,000, and a maximum pain point of ₹26,500, it is good to sell the contract rather than wait for it to expire. Since you get an intrinsic value of ₹300, it makes sense to make a profit and get some value.
The Key Takeaway
In 2004, Max Pain Theory was introduced and is a relatively new theory to test in all respects. Even after many investors have used this concept, there’s no specific literature on this concept to fully understand how to use the maximum pain point for a successful return. In general, the maximum pain theory works on the belief that 90% of option contracts expire meaninglessly, and that there must be a single point in time at which option buyers suffer the most and option sellers least suffer.
Conclusion
The contents of this post will give you a clear idea about max pain, how it works and how it gets calculated. Be sure to go through it to gain a proper understanding.
