DEFINITION of Max Pain
Max pain, or the max pain price, is the strike price with the most open contract puts and calls - and the price at which the stock would cause financial losses for the largest number of option holders at expiration.
The term max pain stems from the Maximum Pain theory, which states that most traders who buy and hold options contracts until expiration will lose money. According to the theory, this is due to the tendency for the price of an underlying stock to gravitate towards its "maximum pain strike price" - the price where the greatest number of options (in dollar value) will expire worthless.
BREAKING DOWN Max Pain
Max pain theory says that the option writers will hedge the contracts they have written. In the case of the market maker, the hedging is done to remain neutral in the stock. Consider the market maker's position if he must write an option contract without wanting a position in the stock.
As the option expiration approaches, option writers will try to buy or sell shares of stock to drive the price toward a closing price that is profitable for them, or at least to hedge their payouts to the option holders. Call writers sell shares to drive share price down, and put writers buy shares to drive share price up, and somewhere in the middle is the max pain strike price.
Tesla Motors Inc (NASDAQ: TSLA) closed on November 5 at $230.97. As of November 6, the graph of the total cash value for each Tesla weekly (November 7 expiration) option strike price looked like this:" data-reactid="37" type="text">All of this jockeying for position herds the share price toward the max pain strike price on the expiration date.
About 60% of options are traded out, 30% of options expire worthless, and 10% of options are exercised. Max pain is the point where option owners (buyers) feel "maximum pain," or will stand to lose the most money. Option sellers, on the other hand, may stand to reap the most reward. The Maximum Pain theory is controversial, and there is disagreement regarding if the tendency for the underlying stock's price to gravitate to the maximum pain strike price is by chance, or by some sort of market manipulation.
Calculating Max Pain
Max pain is a simple but time consuming calculation. Essentially, it is the sum of the outstanding put and call dollar value of each in-the-money strike price.
For each in-the-money strike price for both puts and calls:
- find the difference between stock price and strike price
- multiply the result by open interest at that strike
- add together the dollar value for the put and call at that strike
- repeat for each strike price
- find the highest value strike price - that's max pain
Because max pain can change daily, if not from hour to hour, using it as a trading tool is not easy. However, it is sometimes valuable to note when there is a large difference between the current stock price and the max pain price. There could be a tendency for the stock to move closer to max pain, but the effects may not be meaningful until expiration approaches.