What is Max Pain Theory & How Does it Work?

The world of trading brings you a plethora of terminologies that often leave you confused. One such term- Max Pain, seems to be a captivating concept that plays a significant role in options trading. This concept deals with price movement dynamics when options near their expiration. The fascinating phenomenon of max pain emerges at the point when too many options traders undergo a challenging financial strain. 

The max pain theory is significant in terms of enabling the options market makers or sellers to manipulate the asset’s underlying price. It aids in minimising their losses when the options are near their expiration. Comprehending the idea of max pain theory is crucial for traders willing to make an informed decision when conducting options trading. 

In this post, you can explore the concept of max pain theory in complete detail and learn how it works in the trading market. 

What is Max Pain?

You might be wondering what is max pain in options. This concept entails a financial situation wherein a strike price of the live options contracts is involved. The amount at which the stock will result in the highest number of monetary losses for all option holders is the maximum pain price. Here, options traders have contracts at that strike price when they expire. As the options contract’s expiration date draws near, the stock price max pain bank nifty today—the underlying asset—locks in the striking price. This is how the scenario is described. The maximum pain hypothesis aims to clarify how options traders may suffer enormous losses. This will occur when a strike price of the contract is locked in with the spot price of the underlying asset.

Understanding the theory of Maximum Pain 

The max pain theory explains that when the price of the underlying asset stays fixed at a strike price, the options traders, like put-and-call sellers, are likely to lose money. The amount at which trading of the majority of open options contracts takes place is known as the maximum pain price. We call it genuine interest. It’s the amount that the majority of the option holders would lose money when their options expire.

The majority of traders who buy and also hold the options contracts could potentially experience a financial loss. This would take place until the expiration, which is known as the maximum pain theory. Furthermore, the maximum pain argument holds some merit since there’s a chance—more than 80%—that an option seller will incur a profit.

Max pain theory example

Here is an example to help you understand the max pain theory better. 

Suppose the current trading amount of Nifty50 is ₹17,660. As per the max pain Nifty theory, ₹17,700 strike price of max pain bank nifty today will have a high aggregate of open interest of put and call options. 

Therefore, following the Maximum Pain Theory, the index price might end close to any one of the strike prices on their expiry date. It may also happen that an options trader will face a major loss when the price closes away from the maximum pain significantly. 

How does Max Pain Theory work?

• Following the max pain hypothesis, an increase in the price of the underlying stock often corresponds to a rise in the quantity of worthless options.
• Put, and call writers will want to raise the price of their shares as the options expiration date draws near in order to increase their rewards.
• Option writers can hedge their contracts in order to prevent losing money, according to the max pain chart.
• Thirty per cent of options are worthless, and sixty per cent undergo trading. Ten per cent stay in exercise.
• There is debate regarding the max pain idea. Opponents think it’s just luck or the product of market manipulation.

Max Pain calculation

Time-consuming arithmetic is helpful in calculating the maximum pain, which is the dollar value of each unsettled call or put at the in-the-money strike price. The steps to calculate the max pain chart are:

• Calculate the difference between the stock and strike price.
• At the strike price, get the product of the outcomes and open interest.
• Next, at the strike price, add up the put and call’s dollar values.

• Repeat the process for each strike price.
• The price of maximum pain is equal to the strike price with the highest value.

Since the max pain price varies on an hourly or daily basis, using it as a trading tool is difficult. It is crucial to remember this when there is a significant disparity between a maximum pain price and stock price at the moment.

The max pain theory behind this is that the stock price may have a propensity to oscillate about the maximum pain. Still, the consequences could be insignificant until the expiry draws near.

How do you trade options using Max Pain?

Finding the maximum pain point and basing trading choices on how the stock price moves in relation to this point are vital components of employing max pain in options trading. You may utilize maximum pain to direct your options trading strategy in the following ways:

• Calculate the point of max pain: Using the methods outlined in the preceding response, ascertain the maximum pain point associated with the stock you are considering. Remember that the maximum pain price is subject to regular changes, so be ready to revise your estimates as necessary.
• Monitor stock price movement: Track the fluctuation of the stock’s price in relation to the maximum pain point. When expiry draws near, if the stock price is approaching the maximum pain point, it may be a sign that market makers or options sellers are trying to limit their losses.
• Determine your trading strategy: Create a trading plan based on your observations and evaluation of the stock’s conduct in relation to the maximum pain point. For example, you may purchase or sell options based on your belief that the stock would move towards the maximum pain point.
• Set stop-loss orders: Put stop-loss orders on your holdings to safeguard yourself against unforeseen price swings. This will lessen your possible losses in the event that your prognosis about the stock price is incorrect.

Conclusion

When most options contracts reach their expiration without any value, options traders will experience the greatest amount of financial pain or loss. This is the “ max pain theory“, meaning in options trading. Understanding this idea is beneficial for options traders since it sheds light on possible changes in stock price based on information from options contracts. Traders may develop trading techniques that capitalize on possible market effects by determining the maximum pain point and keeping an eye on stock prices in relation to it.

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