Trading in the expiration week

The Maximum Pain theory states that most traders who buy and hold options contracts until expiration will lose money.

According to the theory, this is due to the tendency for the price of a underlying stock to gravitate towards its “maximum pain strike price” – the price where the greatest number of options (in dollar value) will expire worthless.

As per Investopedia definition, about 60% of options are traded out, 30% of options expire worthless and 10% of options are exercised. Max pain is the point where option owners feel “maximum pain,” or will stand to lose the most money. Options sellers, on the other hand, may stand to reap the most reward.

The Maximum Pain theory is controversial, and there is disagreement regarding if the tendency for the underlying stock's price to gravitate to the maximum pain strike price is by chance, or by some sort of market manipulation.

For example, let's say that a Call option contract for a company, named ABC, costs $1 premium and has a strike price of $20. It has an expiration date of one month out or 30 days. The trader strongly believes that the stock will rise in the coming month. Therefore, he purchases the call option by paying the $1 premium

And let's say that yet another trader bought a Put option contract because he felt that the stock price will fall within the coming month. He purchased the put option by paying the premium at the time; $1 per contract.

If the stock closes at $20, the Max Pain Price, both the call and put options would expire with a value of $0.00. This is the point at which both traders (long and short) would lose money.

What exactly the Max Pain theory tells us is that there is a greater chance that the stock will close at 20$ therefore knowing where the maximum pain strike price is will increase the probability on our trade!

We cannot predict whether the stock will be pinned to the strike by looking at the open interest in ATM option (Max pain price), as we don't know exactly how the delta-hedger are positioned, however we can expect the trading activity to pick up for the stock with the high open interest in ATM options. The impact of the expiry related flow on these stocks will be larger if the open interest represents a significantly large portion of the average daily volume.

Applying the theory to the constituents of the Euro Stoxx 50 index we have the following table:

What should we expect?

“Ceteris Paribus” we should expect stocks like DT, AXA, Nokia to stay “calm” around  their max pain strike, while we could expect Enel, Telefonica or Daimler to be on the move towards their pin.

As all we know trading is not an exact science is an art, therefore you should not base your expiry week strategy on the Max Pain Theory, but you should know it because we need to know where the probabilities are.

Originally posted at www.77sigmatrading.com