The Max Pain Options Strategy provides valuable data on future stock prices. Market forces tend to drive the stock price toward the Max Pain point at the stock market close on option expiration dates. With the introduction of weekly options in addition to monthly options, this means we have an idea of where the share price will close every Friday. For example, Apple stock trades weekly options. With this stock option strategy, you can find out where Apple’s stock price will be every Friday at close.
For call or put stock options, there is an option buyer and an option writer. Max Pain basically means the point at which most open option contracts expire out of the money, thus “pain” in terms of lost premium for option buyers. The opposite of that is that it is the point for less cash paid by option writers. Options writers are usually major players like market makers. These larger players hedge against the option contracts they write. This hedging rebalancing is a major factor in the contributing market forces driving the stock price toward the Max Pain point.
There are two main means of determining the Max Pain point. The first and most accurate method is the cash value method. Here the cash value of all open contracts is calculated. The cash value is the difference between the exercise price and the stock price multiplied by the open interest at exercise multiplied by 100 shares per option contract. By calculating the total cash value of all call and put options for various closing stock prices, you can determine which closing price has the lowest total cash value. This is the Max Pain point.
The second method is simply to look at the number of combined buy and sell open contracts. The highest combined open interest is assumed to be the maximum pain point. This method is inaccurate, however some people use it because any optional data source (CBOE or Yahoo Finance) provides open interest data. You don’t need to do any calculations other than adding the call and putting in the open interest. Therefore, it is quick and easy. Finding the highest combined buy and sell open interest gives you a general idea of where the stock will close. The cash value method is more accurate, and there are free online calculators that do the work for you.
You can make short-term investment decisions using this stock option strategy. If the stock is below this point, you know there will be significant pressure for the stock to go higher, but the option will expire. You can buy the shares directly or through call options. Conversely, if the stock is above this point, you can either short it or buy put options. You should buy longer term monthly expiry options and then trade them as if they were weekly options. The theta of weekly options causes the premium to drop off very quickly.