Maximum Pain is one of those theories out there that can be characterized as unproven, anecdotal, sometimes true & awe/fear/anger-inspiring. It’s essentially a big middle finger to the option-buying public from the Market Makers/assumed option sellers/hedgers.
The theory mostly comes from the general assumption/old-wives’-tale that [make up a percentage, say 80%] of all options expire worthless on Expiration Friday. While this is patently untrue (the majority of options are traded – bought and sold, and not held, well before expiration), the myth remains. In addition, market maker trade hedged, that is, they can have puts and calls, and stock of the underlying to be delta neutral.
Most options are sold by the market makers who leverage them against vast quantities of underlying stock. If they wanted to truly manipulate the market, they could sell/buy the underlying as needed or sell manipulate the futures market (like on May 6, 2010). As net sellers of options, they would definitely have vested interest in seeing as many of those expire worthless as possible to earn as much profit as possible while screwing everyone else.
It is at that this point that we have Maximum Pain for the little guys. It can be found by calculating the total dollar value of all open contracts (based on open interest vs. strike price). Whichever strike gives the lowest total value (held by the options buyers) is the point of Maximum Pain. At this point, the sellers maximize their gain, while the buyers/losers maximize their pain.
We paper traded this theory and we concluded that is not reliable enough to make money consistently in the market. Therefore we do not recommend it for your use. We do believe it is important that you know all the trickery and deception of Wall Street.
Optionistics has an excellent online calculator/grapher, although they call it the “Strike Pegger” (the price to which the underlying will get pegged to cause Maximum Pain). Below is a chart of Apple. According to this, Apple will close around 330, which is the point that most option buyers will lose money. Apple is trading at 346, therefore you should go short according to maximum pain theory. If it only was that easy…
AAPL maximum pain
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I am a dad, professional engineer, MBA student, and a financial fanatic. I can help you make money in the stock market. I use Fibonacci techniques for retracements and targets, technical analysis, some little fundamental analysis, and automated systems trading. I also trade options. In addition, I use CANSLIM to get neat growth stock ideas. No fluff and no BS.
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I have never been a fan of buying options. But selling on the other hand has made me quite a bit of money. I know it’s not big money in the wall street world but you can make an easy 3% return selling index options every month. I mostly sell a spread on the Russell 2000 index about 80 to 100 points away from the strike price either on the top or bottom. The odds are I win 19 out of 20. You can’t beat that.
I am amazed that there are so many who trust in the Fibonacci but I guess you have actually put it into practice with real cash. What is the success rate like?
Thanks for your comment. We do not use Fibonacci for entering or exiting a trade. We trade systems with preset trailing stops. Thus, we do not keep stats on Fibs.
Fibonacci? Does that work? If many trust it I guess it can create some self fulfilling prophecy at some level.
Good article, the problem with options and other derivatives is that they are too complicated for the average trader for that reason there should be more articles like this about derivatives and not only spot markets…
Have you ever used LEAPS?
They’re pretty much options but with 3 year expirations.
I’ve just ordered a book about them, could be good for playing long term ideas.
Interesting….never heard of Maximum Pain before. Any idea how exactly it’s calculated?
The formula goes like this: (#of calls open at strike price*price of the calls+# of puts open at strike price*volume of puts). Plot this number in the Y axis versus the strike price. You will see that the smallest number is the maximum pain point. As I stated, I paper traded this for a year and I can say this theory does not hold water.
Leaps are options over 12 months. I traded them using calendar spreads. I found that they are too risky because they are thinly traded. i rather trade options with less that 6 months to expiration. Volatility risk is a concern with leaps. And in addition, the operators (market makers) usually do not give you good prices unless the stock is highly liquid.
Technical analysis in general is a self fulfilling prophecy if you use the same indicators and parameters as everyone else. I do not. My MACD and stochastics settings are proprietary and tested using statistical methods. Fibonacci works for some people. I am more of a system trader. I use the Fib to spot areas of support/resistance but I do not buy or sell based on it. It is a tool in your toolbox.
put option or call option it is totally a gambling if someone will get something so the other one will must face loss!! mean loss of one’s is profit of second’s!!!
so definitely when we have to bear all the loss it will give maximum pain!!!
Leaps are options over 12 months. I traded them using calendar spreads. I found that they are too risky because they are thinly traded. i rather trade options with less that 6 months to expiration. Volatility risk is a concern with leaps. And in addition, the operators (market makers) usually do not give you good prices unless the stock is highly liquid.
I concur.