Have you heard of options max pain? It’s not easy being an options trader. The deck is stacked against you, if we can be honest. There are so many moving parts with options trading. Time decay, the Greeks, macroeconomic factors, global events, you name it.
Another thing options traders need to worry about is the market makers working against them. Options max pain isn’t often discussed, but it’s one of the biggest reasons that most options contracts expire worthless.
If you are an options trader or want to become one, you should know the max pain price before making trades with your hard-earned money.
In this article, I’ll explore the options max pain, how to calculate it, and how to avoid having your trade become worthless when the contract expires.
Options Max Pain Introduction
Let’s start at the beginning, shall we? Some introductory options are required to understand the options for max pain. Options contracts are financial derivatives that give the buyer the right, but not the obligation, to purchase the stock at a specified strike price by the contract’s expiration date.
There are two types of options contracts. Calls give the purchaser the right, but not the obligation, to buy the stock at a strike price before or on the expiration date. When you buy a call, you generally believe the asset’s price will rise.
Put options in place gives the purchaser the right to sell the stock at a strike on or before the expiration date. When you buy a put, you generally believe the asset’s price will fall in the future.
Selling options tends to have the opposite effect of buying them. When you sell a call option, like for a covered call trade, you believe the price will fall or stay below the strike price. Likewise, when selling a put option, you believe the price will stay above the strike price by the expiration date.
What Is Open Interest?
It is important to know open interest when trading options. It refers to the total outstanding number of options contracts that have not yet been settled. This includes calls and puts for each strike price and expiration date.
Open interest provides a fairly accurate picture of the interest surrounding an asset’s strike price. However, it can change quickly if a whale or institutional player closes out a large position of contracts.
Unfortunately, open interest in options will not be updated until the next trading session. Open interest plays an important role in calculating options’ max pain, and we’ll explain why later in this article.
What Is Options Max Pain?
Look at the phrase “options max pain.” You can probably guess what it means. The options max pain is the price or prices that will inflict the most pain on market participants, usually retail traders.
What is the most painful outcome of an options trade? If you’re buying a call or put option, it means that this contract expires worthless at its expiration date. Have you ever noticed that the underlying asset can see wild volatility as the expiration date nears?
Market makers would attempt to control the outcome of the contracts for the strike prices with the highest open interest.
How do market makers attempt to hedge against these large open interest orders? They write contracts to remain neutral on the underlying stock. They can write calls (sell calls) or puts (sell puts), driving the stock’s price toward the maximum pain price.
Options buyers potentially lose out on any gains made at the maximum pain price, while options sellers tend to make the most profit.
Is this market manipulation? It may appear that way. Unfortunately, there is no evidence or legality surrounding what market makers do.
There is also no proof that the maximum pain price is real. These markets are so liquid that stocks can gravitate towards maximum pain prices just from the ebb and flow of the market each day.
How to Find the Options Max Pain Price
When we talk about market makers and options expiry, finding the options’ max pain price is a difficult task. The calculation for the strike price is quite simple; it’s just tedious. What do I mean by this?
We know that the options max pain price is generally the strike price of calls or puts with the highest open interest. Open interest is the total number of puts or calls that are still outstanding for that particular strike price.
Here’s how to use this readily available data to calculate the max pain price for any option contract.
Identify the in-the-money contracts for puts or calls of the underlying stock.
- Calculate the difference between the price of the stock and the contract’s strike price.
- Multiply that number by the open interest (outstanding contracts) at that strike.
- Add the dollar values of the put and call at that strike price together.
- Repeat Steps 1-3 for each strike price for the stock.
The highest value strike price will be the max pain price for that expiration date.
Note that this calculation works for both put and call options. Since both sides of each trade have a maximum pain point, it isn’t isolated to a bearish or bullish sentiment.
Options Max Pain Example
Let’s examine a popular stock with a high options volume: Tesla (NASDAQ: TSLA). Not only is Tesla one of the most popular stocks among retail traders, but it is also volatile, making it perfect for trading options.
You are looking at trading the weekly expiration call options for Tesla when the stock is at $400 per share. In this scenario, you believe that the price of Tesla’s stock could rise to $425 by the end of the week. Should you go ahead and buy the $425 calls? Not until you check what the max pain point could be.
Scanning the open interest for the weekly Tesla calls will show you that you’re not alone in thinking that $425 is a key level for the stock. If an option strike price has a high open interest, it is likely a significant price for the stock. It could be a key Fibonacci level, a support or resistance price, or even just a round number that has been shown to appeal to the human mind.
Using the calculation from earlier in this article, you’ll see that $425 is the max pain point for Tesla’s stock. So what should you do in this situation?
How to Avoid the Options Max Pain Price
Use the calculation to target other strike prices. Most retail traders tend to buy cheaper, out-of-the-money contracts. In this situation, I recommend looking closer at the current price of Tesla’s stock.
Although the prices are higher, the closer you are to the underlying price, the higher your chances of making a profit are.
You can also consider trading out of it before Friday’s expiration. It is estimated that 60% of all options are closed before the expiration date, 30% expire worthless, and 10% are exercised.
If you are among the 60% of contracts that close before expiration, you have a higher chance of locking in a profit.
Final Thoughts: Options Max Pain
You may be wondering how accurate the options max pain price is and if it’s something you should consider when you enter a trade. As you saw earlier in the article, the option max pain price is completely quantifiable and can be calculated using real data. Does that mean it is completely reliable to use? Not exactly.
As with most market data, trades are constantly opened and closed in the options market. Open interest can change daily and at any time. The option’s max pain price on one day can change the next. You must constantly keep up with the open interest for each strike price if you plan to stay in the trade.
If an institution or whale sells out of a large order, it can directly impact the open interest and the max pain strike price. The max pain strike price can change by expiration, depending on what happens.
The options max pain price can give traders an idea of what market makers might plan to do before the expiration date. Things can change. Assume that this is what would happen in an ideal market setting. Of course, as traders, we know that this is rarely the case. External factors, such as company earnings reports, macroeconomic events, geopolitical tensions, and black swan events, impact the markets.
Frequently Asked Questions
Yes, options max pain prices are generally a good way to determine where market makers might move an asset’s price. Remember that open interest can change daily, and external events can impact the market and maximum pain prices.
