Are you tired of hearing about “max pain” in the stock market through vague references on FinTwit? Don’t worry, you’re not alone — most people who talk about max pain don’t really understand the concept. If you’re curious about what max pain actually means, buckle up and get ready for a no-nonsense explanation that might just help you outsmart the shadowy market makers.
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What is Max Pain?
First things first, “max pain” is a term used in options trading to describe the point at which option buyers would experience the most financial pain. Essentially, it’s the price point at which the greatest number of options contracts would expire worthless, leaving the buyers with nothing to show for their investment.
Now, before you start panicking and selling all of your options, it’s important to note that “max pain” is not a guaranteed outcome. In other words, the house doesn’t always win in options trading. Max pain is simply a theoretical point based on the current positions of option holders and writers. It just so happens that equities have a habit of ending important option expirations near these points of max pain.
How is Max Pain Calculated?
But how exactly is “max pain” calculated? Well, it involves a bit of math and a lot of speculation. The formula takes into account the strike prices and open interest of both call and put options for a particular stock or index. The point at which the total value of both call and put options is at its lowest is considered the “max pain” point.
If you want to skip the equations, you can leave your calculator at home and use this free website to do the work for you.
How Does Max Pain Work?
So why is “max pain” such a big deal in the options trading world?
For one, it can give traders an idea of where market sentiment is heading. If the “max pain” point is significantly lower than the current price of the stock or index, it could indicate that a sell-off is imminent. On the other hand, if the “max pain” point is higher than the current price, it could signal a potential rally.
But why does it work? Two words: Market makers.
What are Market Makers?
Market makers are financial institutions or individuals who facilitate trading in financial markets by providing liquidity to buyers and sellers. Essentially — market makers are the people who sell you options.
In the options market, market makers create options contracts by setting the strike price and premium, which represents the price buyers pay for the right to exercise the option. Market makers make money by collecting the premium on options contracts, and they have been known to use their massive warchests to help push (and at times even manipulate) the market in their favor.
In other words: Max Pain theory suggests that market makers may attempt to move the underlying asset price towards the strike price where the maximum number of options contracts expire out of the money, thereby maximizing their profits. This is because the premium collected on these option contracts represents pure profit for market makers, as the contracts expire worthless and they do not have to pay out anything.
How to Trade Max Pain
Let’s tie it all together: Max pain is a theory that market makers, who are responsible for creating and pricing options contracts, have a vested interest in profiting from the premium collected on the contracts that expire out of the money.
By that explanation, the shortest way to explain how to trade max pain would be that a trader should act as if the “max pain” is where the stock in question is going to close when the relevant options chain expires.
For example, if the “max pain” of a stock’s weekly expiring options is $100, you might use a short iron condor or even a short iron butterfly in an effort to “pin” the stock at that relative price. If the stock is trading far away from the “max pain”, you might consider making a directional trade that the stock will be moving toward that max pain point.
Here’s the kicker: More traders pay attention to max pain during big option expirations. Things like triple witching dates (AKA the third Friday of March, June, September, and December) tend to have a lot of options activity, and thus, could cause a lot of pain.
It isn’t just market makers who are to blame for max pain. Because the theory is so popular, it can become somewhat of a self-fulfilling prophecy — much like many of the common strategies in technical analysis.
But here’s the thing: Nothing is guaranteed. Just because “max pain” can give traders a rough idea of market sentiment, doesn’t mean the theory is infallible. The stock market has a habit of surprising even the most astute and experienced traders — and yes, even the market makers.
The Bottom Line
Max pain is a helpful theory that can teach you to avoid getting caught up in herd mentality when trading options, and to get a glimpse of where the all powerful market makers would like a particular stock to close.