Max Pain how to use options strategy With Examples

Max Pain Theory

Option Pain’s beginnings trace back to 2004, making it a relatively young concept. Surprisingly, no academic papers exist on the theory, leaving one to question why this idea has been ignored by the scholarly world.

The concept of options pain is a result of the view that almost all options come to a worthless end, which provides option writers/sellers with a higher probability of making profits more often than their counterparts who buy options.

Now if this statement is true, then we can make a bunch of logical deductions –

1. It is evident that only one group can come out ahead here – either the option buyers or sellers – and in this case, it would be the latter who are profiting.
2. When it comes to option sellers, they have the potential to reap the greatest profit. This, in turn, implies that the price of the option on its expiry day should settle at a point which minimises any losses for those who wrote it.
3. It is suggested that option prices can be influenced, particularly on the expiry day, if point 2 is valid.
4. If point 3 is accurate, it indicates that there are some traders who can control the cost of options on expiry day.
5. If there is such a group, it would have to be option writers/sellers. They are thought to be the ones who generate consistent profits from trading options.

Taking into account all the information, there must exist a specific price at which, if the market finishes, then it will lead to least inconvenience for those who hold options (or cause greatest distress for option buyers).

To accurately determine the expiration price of a market, identification of the ‘Option Pain’ theory is key. This theory has been designed to pinpoint the price for which option writers experience minimal discomfort, enabling markets to expire accordingly.

Option Pain is a concept coined by optionspain.com that measures the transfer of wealth between option buyers and sellers through a zero-sum game. On expiration days, the underlying stock price often tends to move towards a point of maximum loss for those who have bought options, which is calculated based on all the available options in the market. Hence, Option Pain can be viewed as an indicator of stock manipulation which goes in favour of option sellers.

– Max Pain Calculation

This guide provides one with a step-by-step approach to calculating Max Pain. While it may seem perplexing initially, perusing the details should illuminate matters. To further illustrate this point, an example shall be provided.

Step 1 – List down the various strikes on the exchange and note down the open interest of both calls and puts for these strikes.

Step 2 – For each of the strike price that you have noted, assume that the market expires at that strike.

Step 3 – Calculate how much money is lost by option writers (both call option and put option writers) assuming the market expires as per the assumption in step 2.

Step 4 – Add up the money lost by call and put option writers.

Step 5 – Identify the strike at which the money lost by option writers is least.

This level is the point where there is the least amount of money to be lost by option writers, but maximum pain caused to option buyers. Therefore, this is probably the price at which the market will expire.

To understand this, let’s take an easy example. I’ll assume there are only 3 available Nifty strikes and have taken note of the open interest for both call and put options for each strike.

Scenario 1 – Assume markets expires at 7700

When writing a Call option, money will be lost if the market rises over the strike. Similarly, when writing a Put option funds will only be forfeited if the market drops under the strike.

Therefore, if the market ends at 7700, none of the call option writers will suffer losses. All those who wrote options of 7700, 7800, and 7900 strikes will hold on to the premiums they were paid.

The 7900 PE writers are in trouble. Let’s begin to analyze what this means.

At 7700 expiry, 7900 PE writers would lose 200 points. Since the OI is 2559375, the Rupee value of loss would be –

= 200 * 2559375 = Rs.5,11,875,000/-

7800 PE writers would lose 100 points, the Rupee value would be

= 100 * 4864125 = Rs.4,864,125,000/-

7700 PE writers will not lose any money.

So the combined money lost by option writers if the markets expire at 7700 would be –

Total money lost by Call Option writers + Total money lost by Put Option writers

= 0 + Rs.511875000 + 4,864125000 = Rs.9,98,287,500/-

Keep in mind that total money lost by Call Option writers = money lost by 7700 CE writer + money lost by 7800 CE + money lost by 7900 CE

Likewise, the Total money lost by Put Option writers = money lost by 7700 PE writer + money lost by 7800 PE + money lost by 7900 PE

Scenario 2 – Assume markets expires at 7800

At 7800, the following call option writers would lose money –

7700 CE writers would lose 100 points, multiplying with its Open Interest we get the Rupee value of the loss.

100*1823400 = Rs.1,82,340,000/-

Both 7800 CE and 7900 CE seller would not lose money.

The 7700 and 7800 PE seller wouldn’t lose money

The 7900 PE would lose 100 points, multiplying with the Open Interest, we get the Rupee value of the loss.

100*2559375 = Rs.2,55,937,500/-

So the combined loss for Options writers when market expires at 7800 would be –

= 182340000 + 255937500

= Rs.4,38,277,500/-

Scenario 3 – Assume markets expires at 7900

At 7900, the following call option writers would lose money –

7700 CE writer would lose 200 points, the Rupee value of this loss would be –

200 *1823400 = Rs.3,646,800,000/-

7800 CE writer would lose 100 points, the Rupee value of this loss would be –

100*3448575 = Rs.3,44,857,500/-

7900 CE writers would retain the premiums received.

Since market expires at 7900, all the put option writers would retain the premiums received.

So therefore the combined loss of option writers would be –

= 3646800000 + 344857500 = Rs. 7,095,375,000/-

At this point, we have worked out the amount of rupee value loss option writers could incur at every expiry level.

Having established the total losses that option writers would experience at different expiry levels, it is simple to determine which level the market will settle on.

Based on the option pain theory, the market will close at a point which causes the least amount of discomfort for Option sellers.

From the table, it clearly appears that 7800 is the ideal point, where the combined loss has decreased to around 438277500, which amounts to about 43.82 Crores; a far cry from what was observed at 7700 and 7900.

The calculation is just that straightforward. I chose to use three strikes in the example for the purpose of simplicity, but Nifty in particular has numerous strikes available. Things can get tricky and complicated with so many options, necessitating the use of tools like Excel to help out.

The calculations for this option pain value has been calculated on May 2016: 

We assume market expires at every available strike and calculate the Rupee value of loss for both CE and PE option writers. This is then reflected in the final column, “Total Value.” We can find which point gives the least amount of money lost by plotting a bar graph.

It is evident that the 7800 strike provides the lowest amount of money loss for option writers, which is why this point meets the requirement of the option pain theory; thus, the May series is likely to close at 7800.

Once you have determined the expiry level, there are various ways to put it to use.

Most traders take advantage of the max pain level to identify an appropriate strike which they can write. With 7800 being the expected expiry level, it’s suggested to write call options above that or put options below it in order to get all premiums.