Chapter 5

What is Max Pain?

In tug-of-war, by rule, only one team can win. The side that is stronger and plays as a ‘team’ wins! 

In the options market, too, there is a constant tussle between options buyers and sellers. This tug-of-war continues till the expiry date. And since options trading is a zero-sum game, one team rejoices and the other ends in pain. 

The premise

It is generally believed that options sellers are more powerful. And there are a couple of reasons behind that:  

1. Option selling (aka writing) requires bigger capital as compared to options buying. Sellers have deep pockets. 
2. Institutions and high net-worth individuals, who prefer options selling, have superior research capabilities. They are also called ‘smart money’.

A natural edge

Furthermore, option sellers also have the edge over buyers in certain situations. At expiry, if the option remains ‘out of the money’ or ‘at the money’, it expires worthless, i.e., sellers make money. Thus, in 2 out of the 3 scenarios (except ITM), sellers can make max gain. 

What is Max pain?

Max pain or Maximum Pain is a theory which states that on expiry day, the price of the underlying index/stock moves toward a point that results in maximum loss (pain) to the highest number of options buyers. Alternatively, it also means a minimum loss to option sellers. 

The theory assumes that deep-pocketed sellers with their purchasing power work as a team (remember tug-of-war) to drive prices towards a more profitable point. However, this assumption is controversial. Further, this theory makes one believe that option sellers would always make money, which is also not true. 

Calculating max pain

If you look at it from an option chain angle, max pain is basically one particular strike price out of all the available strike prices of an underlying. At that particular strike price, the option buyers will lose the maximum amount of money or options sellers will lose the minimum. 

How to find the max pain strike price:

1. Pull the list of all the available strike prices and their OI for an underlying, say Nifty50 index.
2. Based on the OI, calculate the loss the option sellers (call + put) would make at each strike price if the index were to close at that strike price. 
3. The max pain is at that particular strike price where the net loss is minimum to the options sellers. 

If the above calculation were to be plotted on a bar chart, it would look like this. Here, put pain (PP) is the loss suffered by put sellers at different strike prices and call pain (PP) shows the loss suffered by call sellers at different strikes. 

Illustration 1: Max pain for the Nifty 50

It must be noted that the OI changes on a day-to-day basis, and so will the max pain. 

Using max pain

Essentially, max pain helps to predict the expiry level. If you know where the market price will end on the expiry, an endless number of option strategies can be deployed. One example is presented here. Traders can sell a call and a put equidistant from the max pain price. Let’s say:

Nifty50’s current price = 17,577

Max pain = 17,600 (expected expiry point)

Days to expiry = 2 days

 

Sample trade

Sell 17,800 strike call  = ₹25

Sell 17,400 strike put = ₹16

As per the max pain theory, since the options sellers would make a concentrated effort to drive Nifty toward 17,600 on expiry, the out of the money options would expire worthless. In this case, the maximum profit in the trade will be ₹41 (25+16).

So this was a quick explainer on the Max pain theory. While it looks pretty straightforward , use the max pain concept with a pinch of salt while taking a trading decision.