What is Max Pain?
Max Pain comes from the maximum pain theory, which theorizes that the majority of traders who purchase and hold options contracts until their expiration date will end up losing money. The theory postulates that the price of an underlying tends to gravitate towards the Max Pain price. This Max Pain price is the options strike where the greatest number of options would expire worthless. In other words, this is the point at which traders would lose the most money. The concept of Max Pain works under the assumption that the underlying market dynamics and market manipulation result in the price gravitating towards the price where traders will lose the most money.
How is Max Pain Calculated?
The Max Pain calculation is computationally complex, requiring the outstanding dollar value of calls and puts for each in-the-money strike to be summated. Quant Data's algorithms automatically compute and display the result of this calculation in a visually appealing graph on the platform's Chain and OI Analysis page. The steps for calculating Max Pain are as follows:
The difference between the strike price and stock price.
The product of the result and the open interest at that particular strike.
Sum the dollar value for the put and call at that particular strike.
Repeat this for each strike price.
Using the results, find the strike with the highest value. This strike is the Max Pain price.
Where can I access Max Pain on the Quant Data Platform?
On the Quant Data platform, we display the Max Pain chart and the Max Pain over time chart on the Chain and OI Analysis Page (here):
You will see the Max Pain chart at the bottom right of the page. On the chart, you will see that you can search for any ticker in the ticker field in the top left-hand corner of the chart. Additionally, you can change the expiration date to see the Max Pain price for the respective expiration dates you want to see. Below is an example of the Max Pain chart:
If you click the Max Pain / Time tab to the right of the Max Pain tab, you will see the Max pain price over each expiration date. It should look something like this:
How do I use Max Pain?
As previously mentioned, the Max Pain theory assumes that the underlying price will gravitate towards the strike where most traders lose money. This can result from market makers or large institutional constituents manipulating prices to the point where options holders lose the most money and where options sellers make the most profit by having the most amount of contracts expire worthless.
With this in mind, we can use the Max Pain price as a predictor of the price range that the underlying will gravitate towards expiration. For example, suppose a company such as Tesla (TSLA) is trading at $300, and the Max Pain price for Tesla on the near-term expiration lies at $285. In that case, we can expect market participants to make an effort to drag the price of Tesla down to or near $285 by expiration. Through observation, you will notice that the underlying tends to revert to this Max pain price. However, it must be noted that market conditions are not linear and that there are controversies surrounding the Max Pain theory since it relies on certain assumptions about market manipulation.
Since the Max Pain price can change significantly due to intraday volatility within the contracts, it is vital to use Max Pain with caution. It is most significant when there is a drastic difference between the current price of the underlying and the Max Pain price.
What is an example of Max Pain?
The two images below show the Max Pain chart for Disney (DIS) and the stock chart for Disney (DIS). As you can see in Image #1, the Max Pain price for Disney (DIS) lies at $118. This $118 price level is the strike price at which traders will lose the most money for the September 2nd, 2022 expiration date. This tells us that market makers are incentivized to push the underlying stock price up to $118 so that most contracts expire worthless. Using this information, we can expect Disney (DIS) to trend upward by this expiration date based on market dynamics.
Image #1:
Image #2:
Things to keep in mind:
Max Pain is a theory that is disputed and holds several assumptions. As with many other analysis tools, there is some degree of uncertainty. So, knowing there is a degree of uncertainty, you must have confluence between different tools before executing.
The more significant the disparity between the current price and the Max Pain price, the more likely price is to trend in the direction of the Max Pain price.
The Max Pain theory intensifies as you near the expiration date. This means that the underlying price is more likely to trend towards and respect the Max Pain price as you near the expiration date of the contract you are observing.
Lastly, the key takeaway is that the underlying stock price tends to gravitate towards the point where most contracts will expire, and most traders will lose money. This price that it gravitates towards is called the Max Pain price.
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