Skill Sheet: What You Will Learn Here
- What is meant by max pain?
- What is the theory behind max pain?
- Calculation of max pain
- Using max pain
Option buyers make losses if the underlying doesn’t move in their favour. A call buyer will make a loss if the underlying price doesn’t go up, and stays where it is.
The put buyer also experiences the same thing if the underlying doesn’t fall or stays where it is. This is because of the theta decay of an option. Theta decay is an enemy of option buyers. In short, an option buyer loses money if the option does not end up in-the-money (ITM). On the other hand, option sellers or writers, as they are known, end up making huge profits when their position ends up at-the-money (ATM) or out-of-the-money (OTM).
Option writers are believed to be much better informed on the market conditions and also have deep pockets, as option selling requires a substantial amount of margin money. Option writers also employ complex strategies to execute non-directional strategies that involve writing calls and puts or hedging their positions by selling calls and puts. By this reasoning, the stakes are high for option writers.
Therefore, option writers would guard their profits or take a minimum hit come what may. This means they will employ all means or whatever it takes, including manipulating the market, to steer it to their advantage. Thus, the buyers would ultimately suffer losses. Max pain is the name for this loss. It is a negative term that means hitting them where it hurts most. So, what max pain is for option buyers implies minimum pain or loss for an option seller. There is, however, no study or empirical evidence to confirm that the option sellers manipulate the market to cause max pain to the option buyers.
Calculation of max pain
Max pain, in effect, is the strike price where the minimum loss is experienced by the option writers and the maximum loss is suffered by the option buyers. Let us understand how to arrive at the strike price that causes maximum damage to the option buyers.
Steps to arrive at the max pain strike price:
Step 1 – List down the strike prices along with the open interest data for a particular expiry for calls and puts alike. It can be for a weekly or a monthly expiry. One can easily download the data from the options chain.
Step 2 – Calculate the profit or loss that the option writers would experience if the underlying value expired at each strike. The profit or loss for both the put and call options with that strike price should be added together in this computation.
Step 3 - Find the strike where option writers lose the least amount of money.
Let us understand this with a small example.
Assume the market expires at 17,100. At this strike price of 17,100, both call and put writers will be making zero loss. Also, the call strikes above 17,100 would not make any losses and end up worthless as they have become OTM. The call writers would be pocketing the premium received. But the put strike prices above 17,100 would all make losses as they have become ITM.
The difference between the individual strike prices and the underlying price is the loss in points for the puts above 17,100. This loss in points multiplied by the open interest (OI) is the loss in value of the put for those individual strike prices. The put strike of 17,200 would make a loss in points of 100, which is the difference between the strike price and the underlying price (17,200-17,100). The put open interest for 17,200 is 44,256. The put loss for the strike price of 17,200 would, therefore, be Rs 44,25,600 (100 x 44,256). Similarly, the put loss for the strike price of 17,300 would be Rs 76,80,200 (200 x 38,401). Likewise, we need to calculate the losses for all the strikes and aggregate them. The aggregate losses for the expiration at 17,100 for puts are Rs 28,36,48,900.
Let us assume the next expiration is at 17,200. The loss for put would be strikes 17,300 and above. The loss for the call would be only the strike price of 17,100. The call loss would be 100 (17,200-17,100) points and the value would be Rs 725,300. The put loss would be Rs 23,15,18,000 and the total loss would be Rs 23,22,43,300 (725,300+2,31,51,800).
The table below is useful for understanding the above examples. In the table, it can be seen that max pain is at the strike price of 17,900. This is the point where the buyers would lose maximum money, and the market would move towards this strike. The sellers, on the other hand, would make maximum money if the expiration happens at this price.
|Strike||Put OI||Call OI||Put value||Call value 17500||Total||Strike|
Using max pain
Max pain can be used to trade if the underlying price is higher or lower than the max pain strike. One can either look to go long or short, depending on the location of the max pain point. One can also use this to close an existing position to book profits or losses. In our example above, the underlying is almost 100 points below the max pain point. In this case, we can either write an OTM put and wait for the market to go up. As max pain gives a probable indication of where the market would expire, one can also initiate a short strangle (selling OTM calls and puts).
A word of caution: max pain is not a tested theory and is dynamic. Trades will need to be keenly monitored.
Things to remember
A call buyer will make a loss if the market doesn’t rise, remains unchanged, or goes against him. The put buyer would lose if the underlying doesn’t fall, rises, or stays where it is. This is because of the theta decay of an option.
Option writers execute non-directional strategies that involve writing calls and puts or hedging their positions by selling calls and puts. Clearly, the stakes are high for option writers. So, they would do anything, including manipulating the market, to safeguard their interests.