What is Max Pain in Options: Definition and Example

In options trading, investors always look for ways to predict market movements and optimise their strategies. One interesting concept that often raises curiosity is Max Pain. Its name may sound ominous, but it is a tool traders use to understand potential price action in the final stages of an options contract. Max Pain is not a theory; it is an idea that makes sense about how market forces, specifically option expirations, can influence stock prices. The article delves into why Max Pain is important and how traders apply it to make the best decisions when the market becomes volatile. 

Options Trading and Some Associated Terms

Options are contracts that grant the holder the right but do not bind them, to either buy or sell a sum of some underlying asset at or before the contract expires at a fixed price. One can buy or sell stocks, ETFs etc., at a fixed price over a certain period of time by online trading options.

• Call Options: A call option is a contract wherein you win the right, but not the obligation, to buy a certain underlying asset at a decided upon price and date between the contracting parties.
• Put Options: A Put option works exactly opposite to the call option. While the call option equips you with the right to buy, the put option empowers you with the right to sell the stock at the date agreed upon by the contracting parties.
• Strike Price: The price at which the options contract was initially bought or the pre-determined price.
• In-The-Money (ITM) option: When the underlying asset price is higher than the strike price.
• Spot Price: The current price of the underlying asset attached with the options contract.

What is Max Pain in Options?

Max Pain is the financial situation that is defined by the strike price of most live options contracts. The max pain price is the price at which the stock would cause the highest level of financial losses for all the options holders who have the contracts at that strike price at the time of expiration. The situation is defined with the stock price (the underlying asset) locking in the strike price of the options contract as the expiration date approaches. The max pain theory attempts to explain how options traders can incur huge losses if the underlying asset’s spot price locks in with the contract’s strike price.

Calculating the Max Pain point

The max pain is a time-consuming yet simple calculation. Overall, it is the total of the outstanding call and put rupee value of every in-the-money strike price. You can calculate the max pain point in the following way:

• Find the difference between the underlying asset’s price and the contract’s strike price.
• Multiply the difference by the open interest at the said strike price.
• Add the rupee value for the call and put options at the said strike price.
• Repeat the above process for every strike price of the contracts.
• After repeating the process for every strike price, the highest value strike price will be the max pain point.

How Do You Trade Options Using Max Pain?

Here’s how you can trade options using Max Pain:

• Identify Max Pain Point: Max Pain is calculated by finding the strike price where the most open call and put options are concentrated. Several financial websites and tools provide the Max Pain level for stocks and indexes.
• Monitor Expiration Dates: Max Pain is most relevant around the options expiration date. As the expiration date approaches, the price tends to gravitate towards the Max Pain point, which becomes important in short-term trading.
• Trade With the Trend: Now that you have the Max Pain level, follow the price action. The stock can be trading much away from the Max Pain point at expiration. As expiration time approaches, the market may take it to the Max Pain level. Traders will use this information to purchase calls and put in anticipation of price action toward Max Pain.
• Use for Hedging: With long options positions, use Max Pain to manage risks. If the price is far from the Max Pain level, reassess your positions to reflect the probability of price movement to such a level.
• Use in Combination with Other Indicators: Max Pain is not a standalone strategy but with other technical analysis tools, such as support and resistance, volume patterns, and trends.

Example of Max Pain

Let’s say a stock, XYZ, is trading at ₹1,000, and its options expire soon. There are 5,000 call contracts at ₹950, 3,000 call contracts at ₹1,000, and 4,000 call contracts at ₹1,050. For puts, there are 4,000 contracts at ₹950, 3,500 contracts at ₹1,000, and 2,000 contracts at ₹1,050. The max pain point is ₹1,000 because it’s where the highest number of options (both calls and puts) will expire worthless. As expiration approaches, the stock may hover around ₹1,000, as it maximises the losses for the largest number of option holders.

Final Words

The max pain theory was introduced in the year 2004, making it relatively new to be tested in all aspects. Even after so many investors use the concept, there is no dedicated literature on the concept where one can fully understand how to use the max pain point to bring profits successfully. Overall, the max pain theory works on the assumption that 90% of the options contracts expire worthlessly, and there must be a single point at which, if the contracts expire, would hurt the options buyers the most and least to the options writers.