Option Pain: Here's All You Need to Know
Risk and volatility are the most common facets of the financial system and cannot be avoided. Nevertheless, this doesn’t mean that financial securities are not rewarded. Laying out the money in financial securities like derivatives, stocks, and currencies is one of the most effective tools for investors to earn significant returns.
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.
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 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.
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Frequently Asked Questions
In general, it is correct to say that option sellers have a greater understanding and thus more control over the price of options than retail traders who are basically option buyers. This means you can utilize the maximal pain theory.
According to the theory, as the option expiration approaches, the stock price will push to the price at which most options (based on the value of rupees) expire meaninglessly. In other words, the theory is that as expiration approaches, the price of a stock or index will be driven towards a price that hurts both call buyers and put buyers alike.
Simply put, option pain is the point at which buyers lose the most and sellers gain the most. Understanding this concept can benefit even option buyers.
A general assumption of the maximum pain theory is that the expiration price tends toward the price at which option buyers experience max pain. If the max pain point is significantly below or above the latest spot price of the market, the trader can gain from the trade by selling or buying futures.
Traders can use this Max Pain to gain or reduce losses on options positions, based on which side the trade is on.
Option Pain is the rate at which an option buyer with Bank NIFTY as an underlying asset can lose the maximum amount.