How to use Max Pain in Trading
In the realm of Futures and Options (F&O), the majority of retail traders are buyers of options. In contrast, it is the big players such as large institutions who engage in option selling. As we have previously mentioned, option sellers assume unlimited risks and therefore possess keen insights into the market. They typically place their faith in the mathematical principles that underlie option selling and take advantage of the fact that approximately 90% of option strikes expire worthless. This enables them to generate a consistent profit.
Below are a few key facts regarding options:
- Options are a Zero Sum game. This means that only one party can profit at a time, either the option buyers or sellers, but not both.
- As mentioned earlier, option sellers tend to generate a consistent profit by utilizing mathematical principles to drive prices toward the strike that results in maximum profit and minimum loss. In contrast, buyers tend to experience maximum loss and minimum gain.
- Therefore, option sellers may attempt to manipulate prices on the expiry day to align with their investments.
When purchasing calls or puts, out-of-the-money (OTM) options expire without value. However, an OTM call can be considered in-the-money (ITM) for a put, and an OTM put can be ITM for a call. This is where the concept of Maximum Option Pain comes into play.
What is the Max Pain theory?
The Max Pain theory, also known as Option Pain, refers to the strike price at which the highest number of options open interest will expire worthless. In simpler terms, it is the point where the combined open interest of both calls and puts is at its peak.
 |
| Nifty Open Interest Positions |
Let’s understand it with the above image that represents the Positional Open Interest of the Nifty having expiry on 11th June. This image is generated by Telegram Bot for free in the real-time, alternatively, you can also check it on the NSE website. The bar indicates the OI at a particular strike.
Strikes
|
Call OI (in lakh)
|
Put OI (in lakh)
|
Combined OI
|
9950
|
0.23
|
1.66
|
1.89
|
10000
|
7.31
|
15.91
|
23.22
|
10050
|
0.51
|
1.60
|
2.11
|
10100
|
8.42
|
8.63
|
17.05
|
10150
|
2.32
|
1.37
|
3.69
|
10200
|
15.79
|
4.71
|
20.5
|
10250
|
1.39
|
0.07
|
1.46
|
10300
|
17.96
|
1.19
|
18.88
|
10350
|
1.31
|
0.03
|
1.34
|
10400
|
12.96
|
0.31
|
13.27
|
10450
|
1.8
|
0.01
|
1.81
|
The strike of 10,200 exhibits the highest combined allocation of calls and puts open interest, as indicated by the yellow-shaded portion. Although some individual strikes, like the 10,300 call, may have a higher accumulation of OI, it is the 10,200 strike that has the highest combined OI. This particular strike is referred to as the "max pain" strike.
It's worth noting that options OI data is constantly changing, and therefore, real-time calculations are necessary.
At present, the Nifty option expiry appears to be converging toward the 10,200 level. While this number alone may not carry much significance, tracking the max pain in real-time can provide insights into whether the price at the time of expiry is likely to increase or decrease.
Is Max Pain a reliable tool for trading options?
While option sellers tend to have a better understanding of the market and can therefore control prices, retail traders can still take advantage of the Max Pain theory. According to the theory, as expiration approaches, the stock or index price will move toward the price that causes maximum pain to the option buyers. This is because the point of option pain is where buyers lose the most and sellers gain the most. Understanding this concept can help option buyers avoid common trading mistakes and profit from the market.
So how can you use the Max Pain theory?
The Max Pain point can shift up or down in real-time, providing an indication of the market's direction. If the Max Pain shifts up on the strike, it could indicate that the market is moving up. Conversely, if the Max Pain shifts down on the strike, it suggests that the market may move down.
The Bottom Line
Remember, the Max Pain theory is a relatively new concept, so it's important to use it in combination with other proven methods such as PCR, price action, OI analysis, or fundamental analysis. With a comprehensive approach, you can make informed decisions and increase your chances of success in the options market. Start implementing the Max Pain theory in your trading strategy today and see the results for yourself!
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