What is Max pain in Options Trading: Options are one of the well-known trading methods which give individuals the ability to trade on the future price movement of the underlying security such as stocks, indices, currencies, and commodities. But trading options is not an easy task.
It requires the market price of the underlying security to reach the strike price in the options contract in order for the buyers to earn profits and there are also many big options writers/sellers in the market who will not allow the prices to go in your direction.
In this article, we will be covering What is Max pain in Options Trading.
What Is Max Pain In Options Trading?
Max pain price or Max pain is the strike price at which the most number of options contract and it is the price point at which, a large number of options buyers would incur losses at the time of expiration.
Max pain is the financial scenario that is viewed from the perspective of option sellers or option writers. It is calculated using the number of open interests for the live option contracts at various strike prices.
According to this concept, both the call option and put option sellers have built up a position at a particular strike price which would incur the least number of losses for them. The sellers will experience maximum pain if the stock prices expire away from their strike prices at the time of expiry.
Therefore, this theory suggests that the price of the stock will ultimately move towards the price at which maximum pain for sellers is present and one can use this to create buying and selling strategies.
How Does Max Pain Theory Work?
The max pain theory proposes that option writers will hedge their contracts to prevent losses.
When the options contract nears expiration, the option sellers/ writers will attempt on driving the prices towards a closing price that is profitable to them or at the very least which will incur the least amount of loss. Here, the call option writers attempt on pushing the price lower, while the put option writers will try to push the price higher.
How To Calculate The Point Of Maximum Pain?
Though the calculation of the Max pain point is simple, it requires a lot of time. It is calculated by aggregating the value of the call and put options outstanding for all the strike prices.
In simple terms, it is the addition of the outstanding open interest on the call and put side found on the option chain which is accessible from the NSE website. Following are the steps required to calculate the maximum number of pain points.
Step 1: Calculate the difference between the current market price and the strike price of the stock.
Step 2: Multiply the answer from Step 1 by the open interest at that strike price.
Step 3: Perform this calculation for both call and put options.
Step 4: Take the sum of values derived from the open interests of call and put options.
Step 5: Carry out the above steps for all the available strike prices.
Step 6: Find the strike price with the highest value.
The resultant strike price will be the point where the options traders will have the maximum pain of incurring the monetary loss.
Manual calculation of the max pain point can be a tedious task and it is definitely possible to calculate the max pain every the price and open interest change. The good news is that this data will be readily available on various websites which saves you the hassle of computing the max pain point on your own.
The image was taken from a nifty trader which is showing the max pain point for bank nifty.
In the above image, the red bars represent the losses for put option sellers at various strike prices and the blue bars represent the losses for call option sellers at various strike prices. The point where the call and the put option sellers both have the least amount of losses will be the max pain point for the option buyers.
Here the max pain point for bank nifty is at the strike price of 41500. Now that we have understood what is max pain in options trading, let’s see how we can trade using the max pain points.
Trading Using Max Pain Points
Since the Option writers put a large amount of capital while writing the options contract, they will try to push the price in the direction that is favorable to them.
Knowing where the options sellers are attempting to push the underlying asset can help the option buyers know which strike price they can buy at.
Let us consider the same image that we used in the above explanation for understanding how to trade using max pain
Here, the max pain point is at the strike price of 41500.
Suppose the bank nifty was trading at the price of 41300, it is recommended for traders to buy a call option slightly below the max pain point.
And if the bank nifty was trading at the current price of 41700, it is recommended for traders to buy a put option slightly above the max pain point.
The reason for suggesting buying a call and put slightly below and above the strike price is, when the price of the underlying security reaches the max pain point, your contracts will become in the money which will help you earn more profits.
Complications In Determining Max Pain
The major drawback of using max pain is that it changes that happen in real-time. As the price of the underlying asset and the open interest keep changing, it will be difficult to ascertain the max pain point that the underlying asset will end at during the time of expiry.
Another drawback of using max pain is, you can pinpoint the max pain point beforehand and enter a suitable position. But, as there is still time for the contract to expire, you will notice any significant impact on the contract. This strategy is more accurate the closer it is used during expiry.
Also Read: 8 Best Books For Intraday Trading – Top Reads For Beginners!
In this article, we discussed what is Max pain in Options Trading, how it works, its calculations, the way you can use it for trading, and its complications
While max pain can help the traders understand where the options contract will likely expire, there is no guarantee that it will always work. Traders should make their own analysis and use max pain as a confirmation that will give more conviction to their trades.
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