Volatility and risk are the most common aspects of the financial system, and you cannot avoid it. However, this does not mean that the financial securities are not rewarding. Investing in financial securities such as stocks, currencies, and derivatives is one of the most effective instruments that can allow investors to make hefty profits. But, whenever you read such financial blogs that infuse financial literacy, one thing is always missing; the potential of losses. However, many investors may want to make profits, there is always a chance of making losses.
Losses are as common as profits for an investor who is not entirely knowledgeable about securities investments For any investor, it is equally important to learn about loss-making factors as much as profits. In this blog, you will earn about one such factor called Max Pain that is included in Options Trading. But first, let’s understand a little about Options Trading.
Options Trading and some associated terms
Options are contracts that grant the holder the right but do not bind them, to either buy or sell a sum of some underlying asset at or before the contract expires at a fixed price. One can buy or sell stocks, ETFs etc., at a fixed price over a certain period of time by online trading options.
- Call Options: A call option is a contract wherein you win the right, but not the obligation, to buy a certain underlying asset at a decided upon price and date between the contracting parties.
- Put Options: A Put option works exactly opposite to the call option. While the call option equips you with the right to buy, the put option empowers you with the right to sell the stock at the date agreed upon by the contracting parties.
- Strike Price: The price at which the options contract was initially bought or the pre-determined price.
- In-The-Money (ITM) option: When the underlying asset price is higher than the strike price.
- Spot Price: The current price of the underlying asset attached with the options contract.
What is Max Pain in Options?
Max Pain is the financial situation that is defined by the strike price of most live options contracts. The max pain price is the price at which the stock would cause the highest level of financial losses for all the options holders who have the contracts at that strike price at the time of expiration. The situation is defined with the stock price (the underlying asset) locking in the strike price of the options contract as the expiration date approaches. The max pain theory attempts to explain how options traders can incur huge losses if the underlying asset’s spot price locks in with the contract’s strike price.
Calculating the Max Pain point
The max pain is a time-consuming yet simple calculation. Overall, it is the total of the outstanding call and put rupee value of every in-the-money strike price. You can calculate the max pain point in the following way:
- Find the difference between the underlying asset’s price and the contract’s strike price.
- Multiply the difference by the open interest at the said strike price.
- Add the rupee value for the call and put options at the said strike price.
- Repeat the above process for every strike price of the contracts.
- After repeating the process for every strike price, the highest value strike price will be the max pain point.
How do you trade options using Max Pain?
As the time for options contracts’ expiration nears, the traders buy or sell the underlying asset such as shares to drive the price towards the direction of a closing price that would be profitable to them. Furthermore, they also try to hedge their positions of payments to the options holders. For example, a call option writer may want the stock price to fall, while a put options writer may want the shares prices to rise.
As per the max pain theory, the expiry price will always cluster towards the price at which the investors will incur the highest loss. Keeping this in mind, a trader can look to either buy or sell the contracts to make profits if the max pain point is sharply higher or lower than the current market price of the shares. For example, if Bank Nifty’s spot price is Rs 25,800, your contract’s spot price is Rs 25,600, and the max pain point is at Rs 25,000, a trader can look towards selling Bank Nifty options accordingly.
Furthermore, traders can also use the max pain point to hedge against losses on options positions or book profits before they incur huge losses. For example, if you are holding Bank Nifty call options with a strike price of Rs 26,700 and the current spot price is Rs 27,000, along with the max pain point being Rs 26,500, it is better to sell the contract and not wait till its expiration. As you are gaining an intrinsic value of Rs 300, it makes more sense to book profits and gain a small-time value.
Final Words
The max pain theory was introduced in the year 2004, making it relatively new to be tested in all aspects. Even after so many investors use the concept, there is no dedicated literature on the concept where one can fully understand how to use the max pain point to bring profits successfully. Overall, the max pain theory works on the assumption that 90% of the options contracts expire worthlessly, and there must be a single point at which, if the contracts expire, would hurt the options buyers the most and least to the options writers.
