Max Pain’s options strategy provides valuable data on future stock prices. Market forces tend to drive the stock price toward the Max Pain point at the close of the stock market on the expiration dates of the options. With the introduction of weekly options in addition to monthly options, this means that we have an idea of where the stock price will close every Friday. For example, Apple stocks trade weekly options. With this stock option strategy, you can find out where Apple’s stock price will be every Friday at closing.
For both call and put options, there is an option buyer and an option issuer. Max Pain basically means the point at which most open option contracts expire without money, thus “pain” in terms of lost premium for option buyers. The opposite is that it is the point for which option writers pay the least cash. Option writers are generally great players as well as market makers. These larger players protect themselves against the option contracts they enter into. This rebalancing of coverage is a major factor in the market forces that help drive the stock price toward the Max Pain point.
There are two main means of determining the point of Max Pain. 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 share price multiplied by the open interest in the exercise multiplied by 100 shares per option contract. By calculating the total cash value of all call and put options for various closing prices of stocks, 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 open buy and sell contracts combined. The highest combined open interest is assumed to be the peak pain point. This method is inaccurate, however some people use it because any options data source (CBOE or Yahoo Finance) provides open data of interest. You don’t need to do any calculations other than adding the call and putting open interest. Therefore, it is quick and easy. By finding the highest combined call and put option open interest, you will get a general idea of where the stock will close. The cash value method is more accurate, and there are free online calculators to 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 from the stock to move up, 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 sell it or buy put options. You should buy longer-term monthly expiration options and then trade them as if they were weekly options. The theta of the weekly options causes the premium to drop very quickly.