Max Pain

What is Meant by Max Pain?

Option buyers incur losses when the underlying asset doesn't move in their anticipated direction. A call buyer loses money if the market fails to rise, remains flat, or declines. Similarly, a put buyer experiences losses if the market doesn't drop, stays unchanged, or moves upward. This is primarily due to theta decay, a phenomenon that erodes the value of options over time. In essence, an option buyer only profits if the contract ends up in-the-money (ITM).

In contrast, option sellers, often referred to as writers, generally gain when the options they sell expire either at-the-money (ATM) or out-of-the-money (OTM). These participants usually have significant capital at their disposal, as selling options requires high margins. They also tend to be more sophisticated, employing complex strategies, including non-directional setups by selling both calls and puts or hedging through strategic combinations.

Given the high stakes, option sellers are motivated to protect their trades at all costs. It's commonly believed they may influence market direction to maximize their benefit. The concept of max pain refers to this: a scenario where option buyers suffer the greatest losses, thereby resulting in minimum loss or maximum profit for sellers. Though this idea circulates widely, there is no concrete evidence to prove that sellers manipulate the market deliberately to induce max pain.

What is the Theory Behind Max Pain?

The theory of max pain is based on the assumption that a market tends to gravitate toward a price level where the combined loss of all option buyers is highest. This indirectly benefits the sellers, who pocket most of the premium. While unproven, this behaviour aligns with the notion that market participants with deeper pockets and higher influence, typically sellers, strive to reduce their exposure and maximize returns, even if it means steering prices toward favourable levels.

Calculation of Max Pain

Max pain is defined as the strike price where sellers incur the least loss, while buyers face the greatest overall loss. Here's how to compute the max pain strike price:

Steps to Identify the Max Pain Level:

1. List down all strike prices for the selected expiry (weekly or monthly) along with their respective open interest data for both call and put options. This information can be easily extracted from the exchange’s option chain, or on mStock’s platforms.
2. Calculate the combined loss for call and put writers at each strike price, assuming the underlying asset expires at that strike. For each price level, sum up the total potential losses faced by sellers.
3. Identify the strike with the least total loss for writers. This strike is considered the max pain point.

Example Illustration:

Suppose the market expires at 17,100:

• At this level, sellers of both calls and puts at 17,100 face zero loss.
• Call options above 17,100 expire worthless (OTM), and sellers retain the entire premium.
• Puts above 17,100 are in-the-money (ITM), causing losses to their sellers.

For instance:

• Put at 17,200: Loss = 100 points (17,200 – 17,100)
  Open Interest = 44,256
  Value loss = 100 × 44,256 = ₹44,25,600
• Put at 17,300: Loss = 200 points
  Open Interest = 38,401
  Value loss = 200 × 38,401 = ₹76,80,200

Continue this calculation across all strike prices. For expiration at 17,100, the total aggregated loss for puts could be around ₹28,36,48,900.

Now consider expiration at 17,200:

• Call writers at 17,100 would lose 100 points × OI = ₹7,25,300.
• Put sellers at 17,300 and above would incur losses totalling ₹23,15,18,000.
• Combined loss = ₹23,22,43,300.

Based on such a table, if the strike price of 17,900 shows the lowest aggregate loss for sellers, that becomes the max pain level. The market is likely to gravitate toward this point, maximizing seller gains and buyer losses.

Using Max Pain

Max pain can serve as a directional clue in trading:

• If the underlying trades below the max pain level, one could anticipate an upward drift and consider writing OTM puts.
• If the underlying is above the max pain level, a potential downside move can be expected, making OTM calls more favourable for selling.

Traders may also use this insight to exit existing trades or initiate positions like a short strangle, where both OTM calls and puts are sold.

Important: Max pain is not a foolproof or static theory. It changes as market dynamics shift. Hence, any strategy based on it should be carefully monitored and backed by additional confirmation tools.

Things to Remember

• Option buyers face losses if the market doesn’t move in their favour due to theta decay.
• Call buyers lose if the price doesn’t rise; put buyers lose if the price doesn’t fall.
• Option sellers deploy advanced strategies and have a vested interest in ensuring options expire worthless or ATM.
• Max pain represents the price where option buyers lose the most, and sellers gain the most.
• While helpful as a reference, max pain should not be the sole basis for trading decisions.