The Max Pain concept was first introduced in 2004. As a result, this is still a relatively new theory. There is no academic/scholarly literature on it as far as we remember, which makes one question why the university has overlooked this subject. Let’s have a look at what is max pain in options in detail.
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What is Max Pain in Options?
the max pain price is the strike price with the highest open options contracts is the price at which the share would lead the majority of option investors to lose money at expiry.
The term max pain comes from the maximum pain concept, which predicts that majority traders will lose funds if they buy and hold options contracts until the expiry.
According to the concept, the price of an option will move towards a maximum pain price, which is sometimes equal to the spot price for an option, causing the most majority of options to lapse zero.
The total of the INR values of pending put and call options for every in-the-money strike price is used to calculate max pain.
How does the Max Pain Concept work?
The maximum pain concept states that the price of an actual asset will attempt to move towards its “maximum pain strike price”—the price at which the highest quantity of options (in cash value) will lapse null.
According to the maximum pain concept, option writers will hedge the contracts they’ve made. Hedging is done by the market maker in order to maintain a neutral position in the asset.
Imagine the market maker’s situation if they need to construct an option contract but don’t want to take a stock stake.
Option writers will try to buy or sell shares of a company as the option expiry date nears in order to drive the market toward a closing price that is favorable for them, or at the very least to hedge their commitments to option investors.
Issues with Max Pain theory
For example, call writers want the stock price to fall, whereas put holders want the stock price to rise. Approximately 60% of options are traded out, 30% of options expire invalid, and 10% of options are executed.
The level at which option owners (buyers) experience “maximum pain,” or incur a loss the maximum capital, is known as “maximum pain.” On the other extreme, option sellers may stand to benefit the most.
The principle of maximum pain is debatable. The likelihood for the actual stock’s price to move towards the maximum pain strike price is a question of luck or an example of market manipulation, according to experts of the concept.
How to Calculate Max Pain?
The following is a step-by-step technique for calculating the Max Pain value. You might find this unclear at this point, but we encourage that you read it anyway.
Step 1
Make a list of all the different strikes available on the exchange, as well as the open interest in both calls and puts for such strikes.
Step 2
Suppose that the market will expire at each of the strike prices that you’ve specified.
Step 3
Determine how much capital option writers (both call and put option writers) will lose if the market expires according to the estimate made in step 2.
Step 4
Add up how much capital call and put option writers have lost.
Step 5
Determine the strike where option writers lose the minimum amount.
Note
The time at which option writers lose the minimum amount of cash is also the point at which option buyers suffer the maximum pain. As a result, this is the most expected cost at which the market will expire.
How to Trade Max Pain Bank Nifty?
As the expiry date for options contracts approaches, investors buy or sell the actual instrument, such as stocks, in order to drive the price in the favor of a positive closing price.
They also make an effort to hedge their payment positions to option investors. A call option writer, for contrast, may wish for the stock price to drop, whilst a put option writer may wish for the stock price to climb.
The expiry price will usually cluster around the rate at which the traders will suffer the most loss, according to the maximum pain concept.
Bear this in view, if the maximum pain point is significantly higher or lower than the actual market price of stock, a trader can profitably buy or sell the contracts.
Banknifty Max pain Example
An investor can sell Bank Nifty options if the current price of Bank Nifty is INR 35,800, your contract’s spot price is INR 35,600, and the maximum pain point is INR 35,000.
Investors can also utilize the maximum pain point to protect themselves against losses on options positions or book profits before they lose a lot of money.
If you have Bank Nifty call options with a strike price of INR 36,700 and the current market price is INR 37,100, with a maximum pain point of INR 36,500, it is best to sell the contract rather than wait for it to expiry.
It makes more sense to book profits and get a small-time value because you are earning an underlying worth of INR 400.
Other Related Terms to Max Pain Meaning
Options are contracts that give the owner the right, but not the obligation, to purchase or sell a certain amount of an actual asset at a defined price at or before the contract expires. Online trading options allow you to buy or sell stocks, ETFs, and other securities at a fixed price for a set period of time. Here are some of the popular terms:
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Call Option
A call option is a contract in which you win the privilege, but not the responsibility, to purchase a specific core asset at a price and date agreed upon by the contracting parties.
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Put Option
The Put option is the polar opposite of the Call option. While the call option gives you the ability to buy, the put option gives you the right to sell the share at the contractual parties’ agreed-upon date.
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Strike Price
The first purchase price of the options contract or a fixed price.
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ITM (In-The-Money) option
When the price of the actual asset exceeds the strike price.
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Spot Price
The options contract is linked to the actual price of the primary asset.
Conclusion
The theory of maximum pain is based on the belief that “90% of options expire worthless, consequently option writers/sellers earn money more regularly than option buyers.”
This is all from our side regarding Max Pain. Let us know your views in the comment section.
Other Interesting Blogs Related to the Max Pain:
What is Span Margin and Exposure Margin?
Frequently Asked Questions About What is Max Pain?
How accurate is maximum pain?
There is minimal suggestion that Max Pain Theory is a consistently reliable short-term trading approach. If traders believe a theory is correct, the price movement will be the same as if the theory is correct.
What is Max pain of BankNifty?
Max pain refers to the point at which option buyers experience the most pain/loss or stand to lose the most capital, while option sellers, on the other hand, stand to profit the most.
Where can I find Max Pain?
There are many websites on which you can find max pain. However, if you want to be confident regarding the value then you need to calculate it on your own by using the steps given in this blog.
What does Max Pain mean in Crypto?
The term max pain refers to a circumstance in which the asset prices hold on to an option strike price as it approaches expiry, resulting in financial losses for as many options traders as potential.
What is OI in option?
The term open interest refers to the quantity of futures or options contracts that are now outstanding or open in the market. On the given contract, the buyer is referred to as long and the seller is referred to as short.
