The name of the game in the stock market is to make money. Period.
Individual investors, all the way up to large firms, will do what they can to earn the largest profit possible.
So, what’s the most painful thing investors can experience? The max pain an investor can feel is taking a huge loss. And “max pain” in the world of options trading says that, theoretically, the max pain price is the strike price where the highest number of investors will lose money.
Now there could be some fishy things going on behind the scenes that cause prices to fluctuate, and move towards the max pain price. For large investment firms that write copious numbers of option contracts, they can sometimes stand to benefit from the underlying price settling at the max pain price, because they can earn a profit as the highest possible number of investors will lose money from their contract(s) expiring worthless. This is why many people think firms with enough capital artificially manipulate the underlying price to move towards the max pain price.
Others think that the tendency for a stock’s price to move towards the max pain price is the result of ‘natural’ causes. Meaning, it’s not because of a few puppet masters pulling the strings, it’s just the psychology of the market.
But without getting too heavy and into the details now, let’s look at a quick refresher on options trading. Then we’ll get into more detail later, diving into what exactly max pain is, how to calculate it, how to use it to your advantage, and some of its benefits and drawbacks.
What you’ll learn
Quick Fresher on Options Trading
Options are derivatives of assets. They serve as an investment vehicle that is tied to what’s referred to as the underlying security (the security that the option is associated with). Using this vehicle, investors are given the right to buy or sell the asset the option is associated with at a set price over a set period of time. There are two types of options: a “call” and a “put”; calls are bullish strategies, and puts are bearish strategies.
Option contracts themselves represent 100 shares of whatever underlying security the contract is associated with.
Let’s break down an example of how an option contract would look on a trading screen and analyze its components. These are crucial terms to understand if you are considering trading options.
Here’s an example using hypothetical data for Ford Motor Company, which uses ticker ‘F’. So we’re looking at an options contract with the underlying security being ‘F’ stock, with an expiration date of April 30, 2022, a strike price of $100, the type of contract is a ‘put’, and the premium is $2.50. Confused? No worries—here’s what all of this means:
- Ticker Symbol: F – this is the ticker symbol of the security that the options contract is associated with.
- Expiration Date: April 30, 2023 – this is the date the contract will expire. Remember in the definitions of calls and puts you have the right to buy or sell stock “over a set period of time”. Your right to buy or sell is between when you buy the contract, and its expiration date.
- Strike Price: $15 – This is the price at which the contract allows you to buy or sell the underlying security.
- Type of Contract: Put – This annotates whether it is a call or a put contract.
- Premium: $2.50 – This is the price you pay for the contract per 100 shares. So in this example the premium is $2.50 per share, so the total price, or premium for the contract is $250.00.
The last set of information associated with basic options trading is knowing whether the contract is in the money (ITM), out of the money (OTM), or at the money (ATM). ITM contracts will cost the most, meaning they have higher premiums than ATM, or OTM contacts. OTM contracts have the lowest premiums of the three.
We’re looking at puts today, so we’ll just talk about those. If a put’s strike price is above the current underlying price, the contract is ITM, because of course it would be better to be able to sell the stock at a higher price than what it is currently trading at. And visa versa, a put would be OTM if the strike price was below the underlying price.
ATM, for both calls and puts, means the strike price is the same as the underlying price.
What is ‘Max Pain Price’ in Options?
The max pain price, or max pain, is associated with the strike prices of options. Whatever strike price has the most options open is the max pain price. One way to think about max pain is, the price where the majority of investors will experience pain (take a loss) at expiration.
Now, the concept behind max pain is not a given certainty of the future. Max pain is a theory. So it is best used as a tool, not a magic crystal ball.
But why is it that the largest number of investors will lose money at the max pain price? How does that work? And why, in theory, does the underlying price have a tendency to move toward the max pain?
There are a few things to understand here:
- Max pain looks at buyers of options contracts as investors, while sellers of options contracts are institutions with much more data and information than investors. Think of the sellers as the casino, where in the long run, the casino doesn’t lose.
- Understanding max pain theory requires a basic understanding options of trading, which we’ve covered above.
- Max pain only applies to options and futures trading.
- The theory requires the underlying stock or index to be highly liquid.
Now, when you look at the chart below, it’s important to understand that we’re viewing it from the perspective of an option seller, not a buyer.
The x axis represents the price of the stock. The y axis represents the loss that the option seller will incur.
The red bars represent the loss to put option sellers, if the price of the underlying stock decreases. So if the price falls, put option sellers will naturally experience an increasing degree of loss.
The blue bars represent the loss to call option sellers, if the price of the stock increased. So, the higher the price of the stock, the more loss will be experienced by sellers of call options.
So, the max pain theory identifies the point where both sellers of call and point options will experience the least amount of total maximum loss. This will likewise be the point where the buyers of put and call options will experience the maximum loss, or in other words, the maximum pain. Based on this, the max main theory suggests that expiration will happen somewhere close to this “max pain” point, as shown below:
Understanding How Max Pain Theory Works
Many will argue that the underlying price moves towards the max pain because of market manipulation. Oftentimes, titan-sized firms are buying and selling shares of the underlying asset to drive its price in a favorable direction. While others think that it is due to chance.
Now, for the firms manipulating the market, this is a common strategy: they will write (sell/ short) options. When you sell or short an option, you earn the premium on whatever contracts you write. This premium (or part of it depending on the direction of the underlying price) can turn into profit if the underlying price stays relatively stable. So if there are fluctuations in the underlying price, large firms with the resources capable of manipulating the price could control the direction of the underlying price and keep it as neutral as possible to capture the most profit.
This is bad news for all of the other investors. If they long calls and/ or puts, once the contract(s) reach expiration they will expire worthless. They’ll lose all the money initially spent, feeling the maximum pain.
So on one side of the argument you have those that believe the market is being manipulated by enormous firms, but who/ what is on the other side? It’s not necessarily just sheer “chance” that underlying prices move towards max pain, it could be a little deeper than that.
Market psychology has a tremendous impact on the movement of prices in the market. It could simply be that the price moves towards max pain because investors are feeling the pressure of the incoming expiration date and they want to hedge their positions. This causes the price to move a little more naturally as opposed to market manipulation by a few major players.
How to Calculate the Max Pain Point
The only pain of calculating max pain is the time it takes, otherwise it’s pretty straightforward. Note that when calculating max pain, only the strike prices that are in-the-money are used.
- Find the difference between a strike price and the underlying price.
- Multiply that result by open open interest at the same strike price.
- Add the dollar values of the put and the call at that strike price.
- Repeat steps 1 – 3 for each strike price listed.
- The strike price with the highest value is the max pain.
A Practical Example of Max Pain
Let’s say PayPal (PYPL) is trading at $80 on Tuesday, July 26, 2022. When you start looking at the various strike prices, you notice that there is a lot of open interest at a strike price of $85.
You perform the steps above and calculate the max pain for PYPL, and you find that it is in fact at $85. Max pain theory states that the price of PYPL will settle at $85 as expiration approaches, causing the highest possible number of options to expire worthless.
This is why people think that market manipulators could be behind the “tendency” for underlying prices to settle at max pain. If PayPal wrote a lot of options, the optimal position for them would be to have the most amount of options expire worthless, so it’s thought that they would manipulate the market to move their underlying price towards the max pain.
Pros and Cons of Using the Max Pain Theory
Max pain is a great figure to know when you’re trading options, but one problem with using it is the frequency that the max pain price fluctuates. This is because the strike prices change quite often – daily, and even hourly. Because of this, using max pain without other supporting data to help make an educated investment decision can be challenging.
Another problem with it is the fact that no one is really sure why the price has a statistically higher chance of settling on the max pain price. This can make it unreliable, as we just touched on.
Now, one thing we all know about the stock market is you can never be 100% sure of the direction of an asset’s price. But we use statistics to increase our percent chance of “sureness”. The more data we add to our investment decisions, the more likely they’re going to work out in our favor. This data could be anything; news you read, chart patterns you recognize, fundamental info, or other factors. Knowing max pain is a great ingredient to add to your preparation of data to make decisions with the highest chance of success.
While max pain is a theory, and doesn’t give certainty, it’s an important value to be aware of, and a useful tool when making investment decisions. You can never have complete certainty in the market; everything is a big maybe with some supporting data.. “It could”, “maybe”, “probably”, “most likely”, but never, “it will”, “definitely”, “without a doubt”.. because, while it’s nice to be optimistic sometimes, we can never be totally sure.
With that in mind, it behooves investors to aggregate as much data as they can into an investment decision. Read the news, look at the company’s financials, see if you can spot some basic chart patterns, look at the stock’s beta, and the like. Adding the max pain price to this list can strengthen your decisions, and mitigate the risk of making the typical mistakes while trading options.
You could decide, for example, to long shares of a stock if you see its current underlying below its max pain, hoping to capture some profit if its price moves towards that price. And if the other data you analyzed also points to the price rising, you have a pretty good chance at realizing some gains.
If you want to see this in action, start to calculate max pain and just follow the price of the underlying as the options near expiration. Consider utilizing the common trading secrets used by many experienced traders, such as logging trades in a trade journal and using an economic calendar to stay ahead of trends. Or, if you’re struggling to find success, think about subscribing to an options trading alerts service to receive signals from experienced, veteran traders regarding potentially profitable moves.
When it comes to max pain, remember – it’s largely a theory. In the end, only you can see for yourself if the theory holds true!
Max Pain Theory in Options Trading: FAQs
How Do You Use Max Pain Theory?
Max pain theory is used in the same way as any other result of analysis. Max pain is essentially a piece of data that you can use in combination with other data to make decisions in the market with the highest probability of success.
What Does Max Pain Mean in Crypto?
Max pain means the same thing in the world of the stock market as it does in the crypto market. The theory can traverse between the two worlds because the concept remains the same in both.
This is an area worth exploring more. Large institutions are just starting to adopt cryptos into their portfolios, much less crypto options. If market manipulation is the factor that directly influences max pain, then we would not see prices settle at a max pain strike price, because there isn’t enough available capital to create a large enough change in the underlying price.
If individual investors, or ‘natural’ means are the fuel behind the max pain theory, then perhaps the theory would hold true in crypto. But again, this is a niche that can, and should be explored more.
What is An Option’s “Pain” and “Gain”?
An option’s max pain is the strike price where investors will cumulatively lose the most amount of money. An option’s “gain” is simply the profit earned from a successful options play.
How Accurate is Maximum Pain?
Because max pain is not a certainty, it’s difficult to pinpoint how accurate it is. It’s better to think about it in terms of how likely it is for something to happen. And with max pain, the concept is that a stock’s price has the tendency to move towards the max pain price. It doesn’t necessarily mean it will always happen X % of the time.
What is Live Max Pain in Options?
The max pain for an option is always moving, fluctuating. The live max pain is whatever the current max pain is. It’s a ‘living’ figure because it is changing constantly.
What Does Low PCR Mean?
PCR means put to call ratio, and a low PCR means there are more calls than puts purchased.
In this ratio, we’re looking at the open interest, or the number of contracts open, for calls and puts.
So the ratio is set up like this: Volume of puts purchased (puts open interest)/ calls open interest. A value of 1 would mean that puts and calls have the same open interest, but if this was the ratio:
600 : 1000 (600 puts, 1,000 calls)
The PCR would be 0.60. This is a relatively low PCR, and we can see that indeed there are more calls than puts being purchased.
Note that “low” is not specific, and is therefore relative. When looking at, or using PCR, express the value in terms of numbers to be as accurate as possible.
What is PCR Value?
PCR value is the ratio between the volume of puts to calls. To find the PCR value, take the volume (open interest, or number of open puts) of puts and divide it by the volume of calls. The result is the PCR value.
What is the Option Pain Level?
There is no such thing as an “option’s pain level”. There is no “level” because the “pain” of options is not on a scale, it is a specific number. Therefore options can’t have a high or low pain level, they just have their “pain” or max pain price.