Welcome to yet a brand new and important article which is going to be regarding the options trading. In this article, we are going to discuss the maximum pain theory. In our previous articles, we had learned about the open interest, call and put option, and put-call ratio.
One of such kind of a pain which can be explained in number and which can be used in a great way to identify the movement and the view of the market, that number is called Max Pain Point. I am here to discuss indicator number 5 which will tell you how to make a view from the pain of the option seller and option buyer and that pain is explained in number which is called Max Pain Point. Now you understand what is Max Pain Point. Now, one question arises. How Max Pain Theory has come up?
I think this theory is very young. It was proposed in 2004 and the common sense about this theory is that whenever people lose money, they get scared of losing money. What they can do to save their losses and if they are going to work hard to save their losses, then they can reverse the market.
Max pain, or called max pain price, is the strike price with the greatest number of open contracts of put and call, the price at which the stock would cause money losses for the largest number of option holders at expiry day.
The term max pain comes from the maximum pain theory, which tells us that most traders who buy and hold the call and put option contracts until the expiration date will lose money. According to the maximum pain theory, the price of an underlying asset moves to gravitate towards its "maximum pain strike price"—the price where the greatest number of options will expire without any money.
Maximum pain theory tells us that the option seller will hedge the contracts they have written so far. In the case of the market builder, the hedging is done to last neutral in the stock. Consider the market builder's position if they must write an option contract without unsatisfying a position in the stock.
As the option contract expiration date comes closer, option sellers will try to buy or sell shares of stock to push the price toward a closing price that is money-making for them, or at least to hedge their return to option buyers. Call sellers sell shares to push the share price down and put buyers buy shares to push the share price up. The max pain strike price lives somewhere in the middle.
About 60% of options contracts are traded out, 30% of options contracts expire without any significance, and 10% of options contracts are exercised. Max pain is the point where the option buyer identifies the maximum pain or will stand to lose the most money. Option sellers, on the other hand, may stand to receive the most profits.
The maximum pain theory is disputed. Critics of the theory are divided on whether the likelihood for the underlying stock's price to moves towards the maximum pain strike price is a matter of luck or a case of market manipulation.
Remember that as I told you that you should not take a trade just based on one or two views or one or two news. You have to accumulate and how to find what it means before placing your hard-earned money. First, become master of that and then all you should go for the real money. You should do a lot of paper trading, virtual trading before investing your real hard-earned money in this.
See in the options market, there are two people. One is the option seller and the other is the option buyer. Now, because institutional investor or HNIs have a lot of money and money is power so what it is believed as per Max Pain theory that they will make the market expire on such a particular strike price where they will not make losses, or at least they should not make a lot of losses. So, this theory assumes that these people with money can manipulate the market in their favor.
In the last article, we had discussed the put-call ratio. What does that tell you? It tells you how many calls have been written against each put and for how many puts have been written against each call. So, suppose in the market, there are lots of people who are selling only calls and suppose that particular strike price is where the maximum seller has sold their calls is 11500, then they want that market should expire below 11000 or at least at 11500 but not above 11500. If the market will go above 11500, they will start making losses.
Suppose the market goes to 11550. Those people will try to pull the market down to their level of 11500 or below. So that what is called max pain point. If somebody has sold a lot of puts and suppose the put has been sold at 11000. Then people will want the market to expire above 11000 or at 11000 but not below 11000 because if it will go below that, the most of the seller is going to lose money.
So, now you can understand that how this max pain theory is important in options trading. But keep remembering one thing that no theory is full proof right. You have to do your calculation to do the desired result.