There is a Wall Street axiom that says “90% of all the options that are bought and held to expiration will expire worthless”. This means that 90% of the time the people who ‘write’ the option and collect the premium, never get their stock ‘called’ from them or get stock ‘put’ to them. Whether the actual percentage is 90% or something lower is irrelevant to the evaluation of the Max-Pain™ effect.
What Is Option Pain?
Option Pain, also known as Max Option Pain or Max Pain, is based on the theory that since most options buyers lose in options trading, the price of the underlying stock must be manipulated somehow to close during options expiration at a price that results in the most options contracts expiring out of the money. If the Option Pain theory holds, it becomes possible to actually predict the exact price a stock would close at during option expiration through charting the open interest of both call and put options. That exact price is known as “Option Pain” or “Max Pain”.
Assumptions of Option Pain
The definition for Option Pain taken from Optionpain.com is:
“In the option market, wealth transfer between option buyers and sellers is a zero-sum game. On option expiration days, the underlying stock price often moves toward a point that brings maximum loss to option buyers. This specific price, calculated based on all outstanding options in the market, is called Option Pain. Option Pain is a proxy for the stock price manipulation target by the option selling group.”
In this definition, we can extract the following assumptions:
1. “Wealth transfer between option buyers and sellers is a zero-sum game”. This means both parties cannot gain or suffer together. In options trading, when one party wins, the other party loses.
2. “On option expiration days, the underlying stock price often moves toward a point that brings maximum loss to option buyers”. This means that on option expiration day, most option buyers with open positions loses money.
3. “calculated based on all outstanding options in the market”. This means that Open Interest is representative of the number of buyers of stock options.
4. “stock price manipulation target”. This means that stock prices can and are manipulated on option expiration days.
5. ” by the option selling group”. This means that a specialized group of traders exist that manipulates stock prices known as the Option Selling Group.
How to calculate option pain for Nifty
In order to compute the maximum pain price, or the price level that will see the greatest number of options expire worthless, one has to compute the total rupee value of all open contracts. Let’s consider an example using the Nifty and the April 2010 Nifty options, which expire in fourteen more days. To start the Max-Pain™ analysis, list the available spectrum of strike prices and total Open Interest volume for the April’10 Puts and Calls. See the table below
Then calculate the cumulative total value of the current Open Interest positions, as if they are held to the expiry day, over a range of closing prices for the ITM Options during expiry , Nifty
After gathering all of the strike prices and open interest numbers for the April 2010 Nifty options, the next step is to compute the cumulative value of the open interest for both the puts and the calls assuming the Nifty closes at various prices. Here will assume that, at expiration, the Nifty closes at a value equal to each of the nineteen strike prices ranging from 4100 to 6000. The process is done for both the puts and the calls.
If the Nifty closes on expiry at 4200, then only 4100 call is at the In the money(ITM) option.Then the value of all the in-the-money CALL options is Rs 17245000 [or (100 x 172450)].
This is the value of the options that will NOT expire worthless if the Nifty is at 4200 at expiration(Just an assumtion ). From table we can see that the cumulative rupee value of the calls increases as the Nifty moves up in price, but the value of the puts declines as the Semiconductor HOLDRS moves higher.
If the Nifty closes on expiry at 4300, then only 4100 call and 4200 is at the In the money(ITM) option.Then the value of all the in-the-money CALL options is Rs 35975000 [or (100 x 14850)] + (200*172450)].
If the Nifty closes on expiry at 4400, then only 4100,4200,4300 call is at the In the money(ITM) option and rest of the call expires worthless.Then the value of all the in-the-money CALL options is Rs 68365000 [or (100 x 19100)+ (200 x 14850)] + (300*172450)].
this process needs to be continued till the end of the strike prices.. in our case it is 6000. The calculation is little large and lengthy :). Also the same procedure needs to be done to calculate the ITM put values at expiration
Finally after computing CALL Value,PUT Value. The next step in finding the point of maximum pain is to add the total value of the open interest for both the puts and calls across the various prices. In table , the total value appears in the last column. The point of maximum pain occurs where the total value is the least. At that level, the most puts AND the most calls will expire worthless, causing the most pain to option owners. In our example, 5300 represents the price of maximum pain.
Stacked Chart is plotted i.e the sum of the PUT Value and the CALL Value. The point at which the most options expire worthless is labeled and is the point where the overall minimum value occurs (the Max-Pain Point™). It appears to be at the 5300 closing price point.
How Should I Read the Call and Put Chart?
This chart plots the total value of calls (blue) and puts (orange) separately. At a specific price point, if the call value is greater than the put value, the stock price may be manipulated below the strike price, making all call options worthless. If the put value is larger than the call value, the stock price may stop above the strike and make the put options worthless.
What Should I Do if I Hold In-The-Money Options Near Expiration?
You may want to sell the in-the-money option, call or put, one week before the final option expiration Thursday. If you hold these options to the last moment, very likely you will see your options become worthless.
How to Profit From Option Pain
It has been proposed from some investment and options trading websites that stocks tend to move towards the Option Pain level as expiration hour approaches and is most predominant in high volume stocks (these are again claims that have yet to be rigorously tested or proven.). Essentially, if you know what price a stock will end up and when, there is almost an endless number of options trading strategies that you can use to take advantage of it. If the Option Pain level is higher than the stock price right now, you could use a Bull Call Spread by buying the At The Money call options and then sell the Out Of The Money call option slightly above or at the Option Pain price. Conversely, if the Option Pain level is lower than the stock price right now, you could use a Bear Put Spread using the same logic. Naked call write and put write at the strike price slightly above or below the Option Pain price works as well.