Max Pain is a fun concept: it’s basically the market equivalent of a bonfire where only options sellers are used as fuel.
To interpret this information, take a look at your options chain.
Typically, Max Pain is indicated by finding the put/call strike that has the largest Open Interest (OI). The idea is that if the market price of the underlying surpasses the strike price holding the largest OI, the options sellers have to pay out the most. Max Pain, get it?
Say you want to pick up some calls and you pull up the options chain. The underlying is currently trading at $98.55. You see the $99 strike calls have an OI of 100. The $100 strike calls have an OI of 65. There’s not much going on until you suddenly see the $105 strike calls with an OI of 5000.
That’s weird, and it tells you two things:
First: There’s been a lot of buyers of the $105 calls—new contracts created are what makes OI increase.
Second: There’s been a lot of sellers of that $105 call— and that’s important because while buyers of options have known risk (price paid per contract), the sellers of calls have unlimited downside risk. That makes them more likely to trade defensively and skittishly.
In this case, Max Pain would be a move through $105 in the underlying equity.
If the stock finishes at expiration above $105, the options sellers will have to cover whatever exercises come their way, representing a loss to their books.
Otherwise, they take all that premium they sold the options for and continue buying their martini lunches.
Questions or suggestions?
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