The options market is often a very watched market as traders believe that is where the big moneyed institutions leave their footprints!
There are a lot of theories like VWAP , Options Pain etc that look at benefitting from these “footprints” and give guidance to traders on potential price movements. The Maximum (Options) Pain theory is amongst the most argued about – and treated with a pinch of salt – though always tracked! While one cannot vouch for whether it works or not, its certainly a concept one should know.
What is Maximum 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”.
The theoretical underpinning behind the Options theory is simple:
1) Sellers of options have loads of capital on the line and it makes sense for them to try to manipulate market expiries to their advantage
2) Retail investors are silly! And would possibly get invested at the wrong price points
This is probably why more than 80% of options expire worthless most of the time!
In other words – leave the silly investor in maximum pain!
Manipulating towards Max Pain
Mostly due to a concept known as time decay, most options buyers lose money. It doesn’t matter whether you’re buying a call option or a put option – due to time decay, you’re probably going to lose money.
In order for an Option buyer to profit, the option needs to expire ITM (in the money). If the option expires At the Money or Out of the Money, the Options buyer will not profit.
Since institutions want you (the Options buyer) to lose money, they want to minimize the number of options contracts that are In the Money. So, order to get to Max Pain, institutions will move the underlying towards a strike price wherein they can get the maximum number of contracts (measured through Open Interest) that do not expire ITM.
The calculation is quite involved especially if you include premia in the whole mix (which itself is difficult most of the time) so you may visit the web for are several websites that show this data live–for the July 2018 expiry this shows 10,700 for the Nifty as on the date of writing this blog,
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.