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Can An Idea Known As 'Maximum Pain Theory' Make You Money?

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Can An Idea Known As 'Maximum Pain Theory' Make You Money?
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As options have become more popular trading instruments for retail investors, new stock trading strategies revolving around option expiration dates have taken hold in the market.

While many retail traders buy and sell options, option writers themselves have a lot to gain from the contracts expiring worthless. Call writers want share prices to fall below the strike price of their contracts, and put writers want prices to rise above the strike price of their contracts.

However, there is one price at which both calls and puts expire worthless: the strike price itself. If a stock closes at a nice round number, such as $100, on an expiration date, all the call options and put options with $100 strike prices that expire on that date will expire worthless.

Option buyers lose, and option writers win.

Of course, there are a wide range of strike prices for any given expiration date, but usually there are one or two strike prices that have an exceptional number of option contracts written for them.

Since the strike price with the most open contracts is the price at which the stock would cause option holders the largest financial losses, this price is referred to as the "max pain" price.

Related Link: Decoding The Stock Market With Quantum Computers

Maximum Pain

The idea behind the "Maximum Pain Theory" is this: As option expiration approaches, option writers will try to buy or sell shares of stock to drive the price toward a closing price that is profitable for them, or at least to hedge their payouts to the option holders.

Call writers sell shares to drive share price down and put writers buy shares to drive share price up, and at the center of the chaos is the max pain strike price itself.

Essentially, all of this buying and selling "funnels" the share price toward the max pain strike price on expiration dates. For example, Tesla Motors Inc (NASDAQ: TSLA) closed on November 5 at $230.97. As of November 6, the graph of the total cash value for each Tesla weekly (November 7 expiration) option strike price looked like this:

The graph shows different strike prices on the x-axis and total cash value that would be paid out on all calls and puts at each strike price on the y-axis. Since a strike price of $235.00 has the lowest cash value of any of the strike prices, $235 is Tesla’s max pain price for November 7 expiration.

Of course, option trading occurs every single day, and the max pain price can change on an hour-by-hour basis. Since Tesla was trading above $244 on the morning of November 6, Max Pain Theory suggests that it might be a good time for traders to take profits before weekly expiration.

In theory, call writers and put writers will be “pushing” Tesla’s share price in the direction of $235 before November 7, and that direction would be down.

Does Maximum Pain Theory Work?

There is little evidence that Max Pain Theory, or "pinning," is a short-term trading strategy that can be relied on consistently. However, it does seem as though certain round numbers have a magnet-like pull on share price during the final hour of trading on Friday afternoon.

The stock market is not a laboratory.

There are no laws that dictate stock price movement, only ideas that do so. If enough traders believe an idea is true, it doesn’t have to actually be true to be a viable trading strategy. If traders believe an idea is true, the resulting price movement will be the same as if the idea were actually true.

A Self-Fulfilling Prophecy?

The only real thing that moves share price is buyers and sellers. While it's nice to see a stock rise because of something good that a company is doing, the money is just as green if the share price rises because other traders are misinformed.

In that sense, Max Pain Theory is possibly an example of a self-fulfilling prophecy. It doesn't matter if the theory actually works, if traders believe it works, they will buy and sell as if it were true. Regardless of the reason, many times the buying and selling drives share price toward the max pain price on options expiration dates.

Posted-In: expirationLong Ideas Education Short Ideas Options Psychology Trading Ideas General Best of Benzinga

 

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