What Exactly Is Max Pain?
The striking price with the most open options contracts (i.e., puts and calls) is the max pain price, and it is the price at which the stock will inflict financial losses for the most significant number of option holders at expiration. The term max pain is derived from the maximum pain theory, which asserts that the majority of traders who buy and hold option contracts until expiration will lose money.
Comprehending Max Pain
The maximum pain theory states that the price of an underlying stock tends to move towards its “maximum pain strike price”—the price at which the most significant number of options (in dollar value) expire worthless.
According to the maximum pain theory, option writers will hedge their drafted contracts. In the case of the market maker, the hedging is done to keep the stock neutral. Consider the market maker’s situation if they are required to construct an option contract but do not wish to have a stake in the stock.
The most significant pain theory is debatable. Critics of the idea disagree on whether the underlying stock’s tendency to trend towards the most incredible pain strike price is due to chance or a case of market manipulation.
Identifying the Maximum Pain Point
Max Pain is a straightforward but time-consuming computation. It is essentially the sum of each in-the-money strike price’s outstanding put and call cash value.
For each in-the-money put and call strike price:
- Determine the difference between the stock price and the strike price.
- Multiply the result by the amount of open interest at that strike.
- Add the dollar amounts for the put and call at that strike.
- Repeat this process for each strike price.
- Find the most valuable strike price. This price is the same as the maximum pain price.
Because the maximum pain price might change daily, if not hourly, employing it as a trading tool is difficult. However, it is worth noting when there is a significant discrepancy between the present stock price and the maximum pain price. The stock may have a propensity to go closer to maximum pain, but the consequences may be insignificant until expiration.
Max Pain Illustration
Assume that options on stock ABC are trading at a strike price of $48. There is, however, substantial open interest in ABC options with strike prices of $51 and $52. The maximum pain price will then settle at one of these numbers since they cause the most significant number of ABC’s options to expire worthless.
Correction for January 16, 2022: An earlier version of this article incorrectly stated that put holders desire share prices to rise. Put holders profit from lower share prices, while put writers profit from higher prices.
Conclusion
- Max pain, or “max pain price,” is the strike price with the most open contracts for puts and calls. It’s also the price at which the stock would lose money for the most option buyers when their contracts expire.
- The Maximum Pain theory says that the price of an option will move toward a “maximum pain” price, which is sometimes the same as the strike price. At this price, the maximum number of options will expire.
- To find the maximum pain, add the dollar amounts of all the open put and call options for each in-the-money strike price.
