Options Max Pain Theory suggests, “On option expiration day, the underlying stock price often moves toward a point that brings maximum loss to option buyers.”
Options trading is a zero-sum game between Option Buyers and Sellers.
- Most options (both calls and puts) expire worthless at the Expiration date. It was first proven by John Summa of on his research paper.
- Various organizations have validated same for Indian Markets. The probability stays in the range of 85–95% based on their setups.
- If we managed to sell at the strike price of the option where the underlying instrument will settle; then it will be worthless at the time of expiry. It has 100% probability of profit.
Max Pain theory
Max Pain theory is based on the assumption that “maximum number of Option “buyers” will lose money” at the time of expiry.
One of the theories for this assumption is – Most Option Sellers are large institutions that hedge their open positions of their portfolio. They have the ability to manipulate the index price to suit their open positions of Options.
It also assumes that at the expiration week, the index moves towards the strike price where the maximum loss occurs to the option buyer (or, minimum loss occurs to the option writer).
This is called Max Pain Strike Price. This strategy tells us the strike price at which the option contract is going to expire with a high probability.
Max Pain Calculator
The current Nifty Pain is 8600. You can find the daily pain. You do not need to calculate with complex excel stuff or refreshing an excel sheet with web queries. The hard task of max pain calculator is already done and live! Enjoy it.
Here are some analysis from this theory –
- Nifty is expected to close at 8600at the time of expiry based on current sentiment.
- To increase profitability let’s take a strike price from higher level like 8800.
- Now you can sell 8800 CE, 8900 CE, 9000 CE if you like call options.
- Or You can sell 8400 PE, 8300 PE, 8200 PE if you like put options.
- This is a form of fundamental analysis. It tells what strike price to enter but you need to consider technicals to make maximum profits. (like, don’t sell in an end of an hourly Bollinger or upper breakouts.)
The max pain theory can be optimized to a huge extent to ensure maximum profitability.
Optimizing Max Pain Strategy
- If you sell 8800 CE. The market is moving up and you want to average out. Then sell twice the lot in 9000 CE instead of selling one lot in 8800 CE. 9000 CE will have a more high beta in reversals than 8800 CE.
- Take a basket of both put and call options if you’re a conservative trader – Selling 8800 CE has less probability of profit than selling all of 8800 CE, 8900 CE, 9000 CE, 8400 PE, 8300 PE, 8200 PE.
- Generally, I take a weighted basket with 3:2:1 allotment where 9000 CE and 8200 PE get 3 lots while 8800 CE and 8400 PE gets 1 lot of allocation.
Then there is a weird set of mathematics comes into scalping as selling all of these are sort of safe trade. These are scalped in high volume in day trading based on technicals. If anything wrong happens, we carry forward.
That’s another story to tell. 🙂
Calculating Max Pain Strike Price
To know the max pain strike price here is what we need to do –
- Write down all the strike prices.
- Suppose the underlying is expired at that price. Now calculate Net P/L of options writers for all those strike prices.
- In the strike price where Minimum of Net loss occurs to Option, Writers is called the Max Pain Strike Price.
|Strike||Put OI||Call OI||Call value||Put value||Total|
I had the Maximum Pain Strike Price of Nifty calculated in an excel sheet by hand. See my results of max pain above. You can see the minimum value of the Total Column belongs to the strike price of 8600.
If you want the entire calculation of max pain which I had, here it is. Please comment if you have any questions on this theory.